<FOOLISH FOUR PORTFOLIO>
Landing on its feet
by Chris Rugaber (TMF RFK@aol.com)
Alexandria, VA (April 22, 1999) -- Last week I discussed inventories and accounts receivable (A/R) and why these two entries on the balance sheet are important. To reinforce the overall point, let me quote from Rule Makers, Rule Breakers, specifically what Tom Gardner had to say about balance sheets: "The� foundation of sound business� is in evidence on a company's balance sheet more than in the twirl of quarterly earnings-per-share figures and their comparisons to Wall Street estimates." This is true whether you're looking for "Rule Makers" or any other kind of stock investment.
In fact, we might be able to argue that one distinguishing factor about Foolish Four stocks is that while their earnings may not be in such great shape, their balance sheets usually are. This is different from other floundering companies where the situation may be reversed -- see the Safeskin (Nasdaq: SFSK) article I mentioned last week, or the example of Nine West (NYSE: NIN) discussed in Rule Breakers, Rule Makers) -- or where both income statement and balance sheet are in trouble. We'll see if this theory holds up as we look at individual companies, but it ought to since it's really just another way of saying that these companies are temporarily "beaten down."
Speaking of Rule Makers, if you've looked into that portfolio you know their "Flow Ratio" was created in part to measure turnover in accounts receivable and inventory as well as in accounts payable. (It also takes debt into consideration.) We won't use the Flow itself when we look at our Foolish Four companies, but we'll use the component parts.
One of the component parts is accounts payable, which is simply the amount a company owes to its creditors, whether they be suppliers of office equipment or of the parts and raw materials that a company needs to produce its products. Generally, the longer a company can delay paying these suppliers,the longer they can use the money for something else. That's good for the company's cash flow. In addition, the ability a company has to delay payment can be an indication of strength within its industry. For example, suppliers to Coca-Cola (NYSE: KO) will grant more favorable payment terms than they would to the makers of Jolt Cola. (Is that stuff even around anymore?)
So, let's consider our Foolish Four stocks, using these metrics. Simply looking at the balance sheet numbers alone doesn't initially tell us much. We have to compare them either to previous balance sheets or to competitors.
We'll start with Caterpillar (NYSE: CAT). Caterpillar's competitors include Deere & Co. (NYSE: DE), the leading North American manufacturer of agricultural equipment, and Case Corporation (NYSE: CSE), which is #2 in the agricultural market and is the leading producer of light and medium-size construction equipment. (The economics of each industry are different, so comparing Caterpillar to a company with a different business model, such as a Microsoft or Dell, wouldn't make much sense.)
Using the 1998 10-Ks, the numbers stack up as follows:
(in millions) Caterpillar Deere & Co. Case Sales 19,972 13,821 5,738 A/R 2,604 4,059 1,594 Inventory 2,842 1,287 1,430 Accts Payable 3,558 2,098 625
For the record, Caterpillar's and Case's fiscal years end on December 31st; Deere's ends on October 31st. All numbers exclude the finance subsidiaries of each company.
Right away, an investor can see that in many ways Caterpillar is doing a better job. Even though it is approximately a third larger, by revenue, than Deere, it has less in accounts receivable and, while having four times the sales of Case Corp, its inventories are only double that of Case.
Yet there are easier ways of measuring these variables. One can compute the turnover of each of these items and measure how many days it takes for a company to either collect on all its receivables, clear out its inventories, or pay all its bills.
To do this, an investor needs to remember that each of these items on the balance sheet is linked to items on the income statement. It is in understanding these connections, by the way, that John Tracy's book How to Read a Financial Statement was particularly helpful.
Let's start with accounts receivable. Again, these are sales that have not yet been paid for, so we need to compare this number to the sales number on the income statement. By dividing the sales number on the income statement by accounts receivable, you can determine how many times in a year (or quarter, if you are using quarterly numbers) a company has collected on all its outstanding sales. In Caterpillar's case, its machine sales of $19.972 billion divided by its machine A/R of $2.604 billion gives you an A/R turnover ratio of 7.67, meaning that Caterpillar collects on all its outstanding invoices 7.67 times a year.
Divide this into 365 days in a year, (365 divided by 7.67), and you arrive at Caterpillar's Days Sales Outstanding (DSO), which for 1998 was 47.59. That means it took Caterpillar an average of about 48 days to get its invoices paid.
Now compare this with Case and Deere, which have DSOs of 124.23 and 101.39, respectively. In other words, Caterpillar collects payment on its invoices roughly twice as fast as Deere and almost three times as quickly as Case Corporation. In addition, this is a noteworthy reduction from 1997, when Caterpillar took about 67 days to collect on its outstanding invoices. So score one (or two) for Caterpillar!
That's probably enough to mull over for this time. Next week we'll look at the other metrics we've introduced and do further comparisons. Fool on!
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Stock Change Last -------------------- CAT -2 1/16 59.81 JPM +1 1/8 142.63 MMM -2 11/16 79.94 IP - 1/8 53.31
Day Month Year History FOOL-4 +1.21% 23.33% 26.83% 28.71% DJIA +1.27% 8.13% 15.63% 15.18% S&P 500 +2.29% 3.87% 9.01% 9.28% NASDAQ +3.26% 1.08% 13.48% 15.04% Rec'd # Security In At Now Change 12/24/98 24 Caterpillar 43.08 61.88 43.63% 12/24/98 9 JP Morgan 105.51 141.50 34.11% 12/24/98 22 Int'l Paper 43.55 53.44 22.70% 12/24/98 14 3M 73.57 82.63 12.31% Rec'd # Security In At Value Change 12/24/98 24 Caterpillar 1034.00 1485.00 $451.00 12/24/98 9 JP Morgan 949.62 1273.50 $323.88 12/24/98 22 Int'l Paper 958.12 1175.63 $217.51 12/24/98 14 3M 1030.00 1156.75 $126.75 Dividends Received $29.45 Cash $28.26 TOTAL $5148.59
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