On Wednesday, we ran PepsiCo (NYSE: PEP) ["da da da da, da, da da da da, da -- the joy of cola...] and Wrigley (NYSE: WWY) ["double your pleasure with Doublemint gum"] through the Flow Ratio.
Pepsi fizzed to the top, scoring a Rule Maker Flow Ratio of 1.01 versus Wrigley's 1.81. According to the Flow, this indicates that Pepsi is doing a better job at managing its cash accounts.
During our industry study, we've measured both of these companies in relation to the other metrics that we want to see in our investments, too. Namely:
- Sustainable market-beating earnings and sales growth rates
- Industry leading management
- Double-digit net profit margins
- Consistently improving business performance
- Reliable dividend payment growth
- Value-adding share repurchase program
- Strong balance sheet
- Industry leadership and long-term viability for more of the same
Both companies met most of these requirements with flying colors. In fact, only one key measure is cause for immediate concern: the desire for double-digit earnings per share and sales growth. Wrigley has only achieved single digit growth in sales and earnings the last two quarters (growth of between 4% and 8%). PepsiCo, on the other hand, has only recently begun to show strong sales and earnings growth again, with 13% earnings per share gains last quarter, and 16% expected this quarter. This performance is excellent, but will it last?
16%, no, that won't last. But is 11% to 12% likely? That sounds possible at Pepsi. However, only time will tell, so if we're going to buy either of these companies, we must present a strong hypothesis for why long-term growth of this strength could likely occur. Luckily, we've already completed much of our due diligence during the past several months, and now we are forming opinions that we'll soon be ready to share (they're still formin'!).
For even more context, today we'll run our investment finalists through another Fool-invented performance metric. The Rule Maker Portfolio invented the Flow Ratio. It also invented the Cash King Margin. Created by Matt Richey, the Cash King Margin is (in Matt's words):
"...the equivalent of the standard net margin, except that it measures profits by using the cash flow statement instead of the income statement. What's the difference, you say? Almost nothing at all, but in fact everything in the world.
"The income statement measures earnings, whereas the cash flow statement measures cash. We prefer the latter. Here's why: Accountants have been known to massage the income statement in order to produce 'earnings.' The income statement includes a lot of stuff that can get between sales and net income, and a lot of those items don't have much to do with a company's cash profitability.
"In contrast, the cash flow statement reveals the unmanipulated truth of what's going on inside the business. While standard net margins are important, what hits the bank account at the end of the day -- CASH, as measured by the cash flow statement -- is a lot more real from an economic standpoint. The Cash King Margin lets us shove all that income statement stuff aside and see what really happens to the money that the company is bringing in via sales."
With that introduction under our belt, here is how you measure a company's Cash King Margin:
(Operating Cash Flow - Capital Expenditures) Cash King Margin = ----------------------- Sales
All of the numbers needed for the measure can be found in a company's SEC report filings, which can be found at http://quote.fool.com, or in your companies' annual reports.
Let's run the Cash King Margin on Pepsi and Wrigley and see how much net income is really being earned after capital expenses. From Pepsi's 1999 annual results:
($3,027 million OCF - $1,118 million CE) PepsiCo = ------------------------ = 9.37% $20,367 million sales
So, Pepsi is showing a Cash King Margin of 9.37%. This compares to its recent net profit margin of about 11%. Although we would like to see a double-digit Cash King Margin, this is close; plus, 1999's performance was just a precursor to what should be a stronger 2000. So, this year the company could likely top 10% in Cash King Margins. Now we'll consider Wrigley's 1999:
($358 million OCF - $127 million CE) Wrigley = ------------------------ = 11.2% $2,061 million sales
Wrigley, which runs a very "clean" business (without debt and without any funky financing), landed a healthy Cash King Margin of 11.2%. In the food and beverage industry, both of these Cash King Margins are above average and even may be considered exceptional. Few companies in the industry are this profitable.
What do these results mean for our two finalists? The Cash King Margins of each company are strong enough that both pass the initial test. As for Wednesday's Flow Ratio test, only PepsiCo passed that, sporting a Flow considerably better than 1.25 (the benchmark) and better than Wrigley's 1.8.
However, given that both companies have generally strong operating results, I believe that our final decision will come down to this question: Which company has a better chance to grow sales and especially earnings per share at double digits for most of the next 17 years? And then, is that company priced attractively enough for us to begin buying it?
If you have a preference between the two, please post it, along with your reasons why, on our Drip Companies discussion board linked below. If you'd rather focus on your own companies in your free time, then consider running your investments through the Cash King Margin (and share your results on the board!). Until next week, be Foolish!
-Jeff Fischer, TMF Jeff on the discussion boards.