Sickly McKesson HBOC No Bargain; Donna Karan Slowly Unraveling

McKesson HBOC (MCK)

Jim: Don’t buy

Mike: Don’t buy

Jim: This outfit is known on Wall Street for all the wrong reasons, because lots of McKesson HBOC stockholders got bloodied after too many people ignored too many red flags about this company.

Mike: That’s right. But first explain to our readers what this company does.

Jim: McKesson HBOC is mainly a wholesaler of drugs and other medical supplies. It also used to own Sparkletts, but sold that business this year.

Mike: Too bad; that’s the one business most people can easily comprehend.

Jim: But McKesson also bought a company in early 1999 called HBO & Co., which is in the health-care software field.

Mike: No relation to Home Box Office.

Jim: Correct. Now, HBOC had been a highflier, but only a few months after McKesson bought it, guess what? It dropped a bombshell that more than $44 million in revenue that HBOC had recorded was, uh, not really there. So all hell broke lose. McKesson’s stock got routed. A torrent of lawsuits alleging accounting abuses were filed. The chairman and four other executives got fired.

Mike: And since then, its new management has engaged in all sorts of overhauls to save this ship, which are costing McKesson plenty. Yet that mess still hangs over this company.

Jim: So what do we have here now, Mike?

Mike: A health-care supply and software house that isn’t doing very well, accounting scandal or not. The supply business is very competitive, with lots of new entrants, and HBOC’s software business is struggling. So we have another company here with its work cut out.

Jim: In the last two months McKesson’s stock has moved up--it was in the midteens and now trades around $25, which is why some of our readers asked us to take a look at it. But I think this upswing is a head-fake. I don’t see any major improvement in McKesson’s core businesses any time soon, the accounting hassle is one more liability and I’d simply avoid the stock.

Mike: Agreed. There isn’t much smooth sailing ahead. Now, McKesson is trying very hard to migrate a lot of its business to the Web. But once it gets there, it’s going to discover that there are a lot of companies already there doing what it does.

Jim: And McKesson’s performance in the meantime isn’t good. In its fiscal year that ended in March--if you throw out all the special charges--their earnings from their basic business dropped 23% from the prior year. Then in its fiscal first quarter that ended June 30, they dropped an additional 20%.

Mike: Look, there’s probably no business in the world that needs better management and efficiency than the health-care industry. In addition, a lot of health-care clients--that is, McKesson’s clients--are less and less in a position to pay a lot of money for these services because they’re strapped themselves.

Jim: Your point being that McKesson has little room to screw up.

Mike: Yes.

Jim: In fact, I’ve seen some analysts who are predicting that McKesson won’t be able to exceed its 1997 earnings until 2003 at the earliest. And there’s another thing that bugs me about this stock: Despite the hammering it took, it’s still selling for 24 times its expected per-share earnings for this fiscal year. That’s hardly a bargain.

Mike: I noticed that myself. Any company that has this much work ahead to get its business in shape shouldn’t be valued that high.

Jim: Absolutely. I wouldn’t buy this stock if it was selling for a price-to-earnings multiple of 12, never mind 24.

Donna Karan International (DK)

Jim: Don’t buy

Mike: Don’t buy

Mike: Now here’s a company that carries a pretty glamorous name.

Jim: Too bad its stock is so unglamorous.

Mike: Ummm-huh. As we speak, I’m eyeballing a recent report from a Merrill Lynch analyst whose ranking on Donna Karan International stock is “accumulate.” Now in Wall Street terms, rating a stock “accumulate” is akin to calling your girlfriend’s new hairdo “interesting.” Because this is the closest most Wall Street analysts ever come to saying “sell.”

Jim: Donna Karan, of course, is the New York apparel designer. Her company went public in mid-1996 at $24 a share, and it’s been coming apart at the seams ever since. This outfit is another example of how the reputation and hype attached to a name often have no bearing on how a company or its stock will perform, and this is especially true in the rag trade.

Mike: They still apparently love Donna on the runway.

Jim: But not on the Street. Right after Donna Karan went public, the company’s earnings started sagging and the stock started dropping. It’s been rough sledding ever since.

Mike: That’s all true, Jim, but I want to put my finger on the albatross that is really dragging down this company.

Jim: What would that be?

Mike: It’s something called Gabrielle Studio, and it’s such a remarkable factor in this company’s condition that I want to get to it right now.

Jim: I don’t blame you. Enlighten us.

Mike: Gabrielle is a separate company, named after Donna Karan’s daughter, that is owned by Madame Karan and her husband, Steven Weiss, who’s vice chairman of Donna Karan International. To me, the scandalous element of all this is that Gabrielle Studio owns all the trademarks--Donna Karan, Donna Karan New York, DKNY and DK--and licenses these trademarks back to Donna Karan International at a very handsome price.

Jim: Handsome as in millions of dollars a year, which basically go from the stockholders’ wallets into Gabrielle’s, like coins dropping through a hole in your pocket.

Mike: Right. The royalty expenses amounted to about $17.6 million in 1997, $19.5 million in 1998 and $25 million in 1999, according to the company’s proxy statements. This year, according to Wall Street analysts, the royalty will reduce the company’s pretax profit margin by four percentage points.

Jim: And there’s not much of a profit in the first place. Gabrielle’s take last year was more than twice the $10-million profit earned by all of Donna Karan International. The company’s 1999 sales, incidentally, were flat at $662 million.

Mike: It’s ironic: Back in ‘97, the company was doing so poorly that Donna Karan herself had to lend it $6.7 million, which presumably is money she partly got from her royalty arrangements. Why doesn’t she just turn over the trademarks to the shareholders?

Jim: Because she likes the money?

Mike: It’s not funny. She’s the company’s chairman. The company exists to make and market her clothing, but it has to pay her for her name? I should add, by the way, that she’s a major shareholder herself, owning some 24% of the stock. But she also pulled down $765,000 last year in salary and bonus, which, to use an apparel business term, isn’t too shabby. You know, this isn’t the only arrangement we’ve seen where a company’s top officers have some sort of special deal with the corporation. We haven’t liked the others, and I don’t see why we should like it here.

Jim: It is ludicrous. Now, if Donna Karan International were prospering that would be one thing, but it isn’t. The apparel trade is notoriously fickle, and it’s extremely hard for even the most famous houses to stay in front of the pack. Look at Tommy Hilfiger--over the last four years, Hilfiger’s stock has lost more than 60% of its value, and Donna Karan’s stock has lost nearly 80% of its value. And these are two of the big names.

Mike: Yeah, it sort of parallels the retail markup on fashion merchandise. The moment you turn it over to the thrift shop, you’ve lost about 60% of the value.

Jim: Also, this company has struggled since its inception to control costs, which is one reasonit’s gone through at least two restructurings. And Donna Karan herself turned over the chief executive’s job, the day-to-day operating job, to one John Idol in 1997.

Mike: Any relation to Billy?

Jim: I don’t think so. John Idol is a former Polo Ralph Lauren executive, and he’s still in place at DK, but he hasn’t strung together the consistent earnings growth to get the stock rallying, either. So the shares are just languish, and I don’t see that changing much.

Mike: Also, don’t be fooled by this stock’s cheap price or its extremely low price-to-earnings multiple of 10. This is a stock that’s fairly priced right where it is.

Jim: I would say exceptionally fair considering this company’s prospects.

Mike: Yes, DK has got trouble in retail. It’s got trouble with its outlet stores. It’s got staffing problems. It’s got problems identifying and serving its market. For example, the average DKNY customer is a 40-year-old working woman, and yet this year, apparently, the company’s product line was pitched to younger women and they didn’t buy.

Jim: A common mistake in apparel--guessing wrong on trends.

Mike: I’d add that one bright spot with this company is its royalty income. I’m not talking about Gabrielle here--this is the money Donna Karan International gets for letting other firms plaster “DK” over all sorts of merchandise from perfumes to handbags. But you have to keep your eye on the quality and quantity of what you’re putting your name on, so the whole trademark doesn’t turn stale.

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Peltz (james.peltz@latimes.com) covers the markets and corporate financial trends. Hiltzik (michael.hiltzik@latimes.com) covers technology and entertainment and is the author of the book “Dealers of Lightning: Xerox PARC and the Dawn of the Computer Age” (HarperBusiness). Either can also be reached at Business Section, 202 W. 1st St., Los Angeles, CA 90012.

You can hear a preview of Peltz and Hiltzik’s weekly column Mondays on the KFWB-Los Angeles Times Noon Business Hour on KFWB-AM (980).