Tuesday, May 5, 1998
Towaco, NJ (May 5, 1998) -- Today Im going to talk about some questions that come up frequently on our message boards. Questions like: Can a bank be a Cash-King? Why do so many banks always seem to come up when I run Cash-King stock screens? How do I convert a banks financial statements into a format that allows me to look at it from a Cash-King perspective?
Im also going to share the results of some preliminary work that Ive been doing in trying to determine which, if any, banks can be considered to be Cash-Kings. Tomorrow I plan to take a bank through the paces of Step 6 of the 11 Steps to Cash-King investing Cash-King Criteria.
Off the top of my head, Ive got to say that it seems that a bank could very well be a Cash-King, as banks are almost unquestionably the kings of cash. But handling money does not always mean making money, as accounting conventions can make some lenders appear more attractive than they really are (much more so, on occasion).
One of the characteristics that may work against finding a bank that qualifies as a Cash-King is that there are very few that right now have a global consumer brand. Realistically, only the money center banks could possibly pass this test, and a quick glance through the financial industry shows that there are only 5 such banks Bank America, Bankers Trust, Chase Manhattan, Citicorp, and J.P. Morgan.
However, the recent consolidation in the banking industry is leading to the creation of a number of monster banks. Some of these such as NationsBank (which recently announced plans to merge with Bank America) and First Chicago (which recently announced plans to merge with Banc One) are actually much larger on a revenue basis than Bankers Trust.
I think that in the case of banks we can probably relax the global presence requirement a little bit and expand the definition to include those with either a strong global or national presence. That said, the 21st century is going to demand of all leaders in this industry that they expand globally. While the nature of the banking business doesn't demand branches on foreign soil, the opportunities for growth (and balance) are substantial 'round the world.
If we go through the rest of the non-numerical Cash-King criteria, its easy to say that just about any bank exhibits a repeat purchase business. After all, every time you make a deposit, withdraw money from an ATM, write a check, use a credit card, or make a payment on an outstanding loan, youre reminded of how much easier banks can make your life. Without banks, most of us would never be able to raise enough capital to purchase our first home or first car. Cashing our paychecks would be a hassle, too.
Of course, banks also provide one of the easiest ways to get you in trouble. Some of them regularly try to entice you to get further and further into debt, and send you regular reminders of how easy it is to obtain credit. Some banks are also not supportive of a Fools quest to manage his or her personal flow ratio (something discussed in my column of February 13, 1998 -- Your Personal Flow).
Its certainly possible for banks to sport strong historical performance as well. BankAmerica shares have gone from $14 to $85 over the past ten years. However, the dependence of a bank's business model on interest rates has made it considerably more cyclical than the typical Cash-King. That makes us uncomfortable. And it makes me doubt that well be able to find a bank that has the consistent year-to-year performance of some of the other companies in our portfolio, like Coca-Cola. Take, for instance, Citicorp, which was in major trouble due to a number of failed loans to Latin America. This major lender could easily have gone bankrupt earlier in this decade.
Okay, so other than relaxing the requirement of a global presence a little bit, I havent come across any significant differences between the selection criteria for our current portfolio holdings and banks. Now we come to the more difficult part -- the numbers. Heres where the similarities start to end. The financial statements of banks use lots of different terminology that most of us arent entirely familiar with, and our C-K financial criteria really aren't appropriate for evaluating banking companies. For the fun of it though, I'd like to spend today just matching our requirements one-for-one with the banks... just to point out some key differences.
We'll start with the easiest criteria to track: As far as size goes, its relatively simple to find banks with revenues of at least $1 billion a year. Also, many banks also are capitalized over $5 billion in value. No problems there.
To move into the more complex financial items, I decided to evaluate twelve banks. I started with the five money center banks named above and added First Chicago, Fleet Financial Group, Mellon Bank, NationsBank, PNC Bank, Regions Financial, and Wells Fargo.
In our research we typically look for gross margins of at least 50%. Were off to a great start with this group as the groups average gross profit margin is 70%. We also look for a net profit margin of at least 7%. Again, weve got no problems. The average for the group is 13.3%. Interestingly, in both cases the regional banks fared better than the money center banks.
Next I looked to see whether or not these banks had cash of no less than 1.5 times long-term debt. I certainly wasnt surprised to find that on average this group had cash levels more than 4 times greater than their long-term debt. In this case, though, the money center banks substantially outperformed the regionals. The average flow ratio of the group was a stellar 0.6. So, were actually looking pretty good. It seems as if it could be pretty easy to find banks that meet our existing criteria.
But you know what, there are a number of inversions that we have to make when assessing banks. I'll talk about these in the days ahead. But consider the biggest difference of all as a reminder of the differences between banks and our other consumer franchises. Its kind of a loose guideline that we like to find companies with Days Sales Outstanding (DSO) of less than 50 days. We want our businesses to collect their receivables promptly.
Well, our twelve banks don't even come close to that kind of performance. The money center banks had an average of 1,854 days (approximately 5 years) outstanding. The regionals were even higher at close to 2,588 days (approximately 7 years)! This is primarily attributable to the fact that banks loan people money. They dont expect to be paid back quickly. In fact, they dont want to be paid back quickly. After all, one of the primary ways that they earn money is through the interest that they charge on their loans.
Sounds to me like the numbers we look for in Cash-Kings will have to be modified for banks. Of course, its also possible that well have to come up with some other criteria as well. Ill be back tomorrow to explain how I calculated these numbers for one of the banks mentioned above. In the meantime if you have any questions, please share them with everybody in our Cash-King Message Folder.
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