This Stock Got Killed
by Tom Gardner
Alexandria, VA (July 30, 1998) -- This past week, Network Associates (Nasdaq: NETA), the developer of network management and security software, announced that it will buy out Cybermedia (Nasdaq: CYBR) for $9.50 per share in cash, or $130 million. The story of Cybermedia's two years in the public markets -- with its stock rocketing to $33 last winter before plunging to $3 earlier this spring -- provides a valuable investing lesson for all Fools.
For veterans of the Cash-King portfolio, it offers even more.
Cybermedia came public in the Winter of 1996, underwritten by Hambrecht & Quist. The stock traded up into the mid-$20s on its first day. And why not? The company had a promising story; it was the ultimate small software shop, dedicated to support & solutions in a world where computer users are hungering for clarity.
At its IPO at the end of 1996, the company had trailing sales of $17 million, up from just $240,000 two years before. Over the next six quarters, Cybermedia appeared to go ballistic. It closed out 1997 with more than $71 million in trailing revenues. Wow. The stock bounced around, as any small-cap is wont to do, before climbing the hill to $33 per share in November 1997 -- just eight months ago.
Cybermedia's troubleshooting software -- First Aid, Oil Change, Guard Dog Deluxe, and UnInstaller -- was flying onto the shelves of retail channels across the country. Its applications were winning technology awards from PC World and PC Magazine. Its 5-year rate of sales growth hit 413% per year. And last year, on Halloween, shareholders were beaming. The stock was at its all-time high.
Then, sound stopped.
It was a bit like the last click of knotting bicycle gears before an ugly frontward tumble. The company posted third quarter earnings, and the dreaded -- but often overlooked -- accounts receivable line on the balance sheet skyrocketed to $25 million. Cybermedia started selling off. In January, the VP of International Sales, Leonard Backus, stepped down. Then in February, CFO Jeffrey Beaumont followed him. Fast on their heels, CEO Unni Warrier resigned in March.
The Cybermedia ship sailed off and away, rudderless in choppy waters, with no skipper or lead officer to guide it. And the stock plummeted from $33 in November 1997 to $4 two weeks ago. That translated to a drop in the company's value from $425 million to $50 million in less than a year.
What the heck happened?
Well, Cybermedia had been announcing as sales the delivery of its products to retail distributors. If the retailer couldn't sell them, they could be returned to Cybermedia without payment. Bad news. Throughout its public history, Cybermedia's uncollected sales were growing at a faster rate than its collected sales. Pause on that for a second -- it's a very bad sign. Uncollected sales mean a company announces sales for which it receives no cash. Spy our little two-line play:
Company: Sales are going through the roof!!!!!!!
Cash-King Investor: Uhh, really?
Thankfully, mere Fools could have seen the disaster coming. The theory behind the Foolish Flow Ratio (C-K Step 7) would have turned up the receivables problem at Cybermedia right there in its IPO prospectus. Investors who spotted it missed out on the nearly 88% decline from Cybermedia's offering price in 1996 to its dreadful low in mid-July.
Now, some folks have had trouble digesting this Foolish ratio, so I'll try to be clearer this time through. The Foolish Flow is one of the most important elements of the Cash-King portfolio. It holds that non-cash current assets are, in fact, liabilities.
Well, inventory and uncollected sales, which are listed as current assets, are actually weaknesses of a business. Who wants unsold product (inventory), and who wants uncollected sales (receivables)? These items are negatives for any business. Fools don't like 'em, no sir, not at all.
On top of this, The Flowie holds that current liabilities are, in fact, assets. All those unpaid bills reflect a company's ability to stave off its partners and keep that cash working for its own business. So long as the company has plenty of cash to pay down its current dues, what's the rush to do it today?
It is upon these basic principles that The Flowie rests. And the simple balance-sheet calculation for The Flow Ratio is:
current assets - cash & equivalents ------------------ current liabilities
We like to see the Flow Ratio low -- preferably below 1.0 -- and falling. That would mark a company moving product quickly out the door, collecting payments upfront from its sales outlets, and paying its supplying partners slowly. In more technical terms: Non-cash current assets run low, current liabilities run high. Not every company can pull this off. Typically the few that can have created such huge buying demand that all entities begin yielding to them (aka Microsoft, Coke).
Now take a look at Cybermedia's Flow Ratio from 1995-1997:
1995: 0.51 (excellent)
Without knowing anything about the company, a Fool could see that as Cybermedia headed into the public markets in 1996, it was getting sloppy about product management. Sales growth was phenomenal, but the growth in uncollected sales (receivables) was outpacing it. Ugh.
Cash-King investors would've put Cybermedia on its Whoa There, Watch Out! list at its IPO in late 1996. And the upward direction of its Flow Ratio throughout 1997, even as the stock rose, would've lit the night sky with warning flares from quarter to quarter. Stay away!
In fact, it's a shame that a ratio like the Flow has to even be created to measure this stuff, but our nation's flawed accounting principles enable a public company to announce as sales that which they haven't yet collected on. So, right now, we need Flowie.
I'd like to see the ratio undermined, though, even though I created it and love saying the word "Flowie." It could be severely weakened by a change in accounting principles that forced companies to keep all uncollected sales off their income statement -- restricting them from announcing sales until they've been collected.
I say -- Give companies room to mention receivables as a sort of deferred revenue on the balance sheet, if they like. But why create unnecessary shadows on the income statement? Accounting is supposed to make the purity of growth visible, not to obfuscate it.
And this sort of change might even cause the P/E ratio to be as important as some financial journalists think it is today -- slightly restoring our nation's faith in the media! Purify the sales and earnings and the price-to-earnings ratio will matter. Otherwise, Cash-King investors will have no choice but to continue eating the public market's lunch for years to come.
Which I guess is fine.
Tom Gardner, Fool
Author's Note: Drop by the Cash-King Companies message folder and share with us your favorite pharmaceutical company that meets our C-K criteria. Help us find our next purchase. And Fool on.
Day Month Year History C-K +2.26% 3.98% 18.59% 18.59% S&P: +1.58% 0.80% 14.15% 14.15% NASDAQ: +2.03% 1.31% 16.14% 16.14% Cash-King Stocks Rec'd # Security In At Now Change 2/3/98 24 Microsoft 78.27 113.38 44.85% 2/3/98 22 Pfizer 82.30 112.00 36.09% 2/27/98 27 Coca-Cola 69.11 82.75 19.74% 5/1/98 37 Gap Inc. 51.09 60.50 18.42% 6/23/98 23 Cisco Syst 86.35 98.44 14.00% 5/26/98 18 American E 104.07 113.88 9.43% 2/6/98 56 T. Rowe Pr 33.67 36.56 8.58% 2/13/98 22 Intel 84.67 87.69 3.56% Foolish Four Stocks Rec'd # Security In At Value Change 3/12/98 20 Eastman Ko 63.15 85.50 35.40% 3/12/98 20 Exxon 64.34 72.06 12.01% 3/12/98 15 Chevron 83.34 85.25 2.29% 3/12/98 17 General Mo 72.41 73.19 1.08% Cash-King Stocks Rec'd # Security In At