Two months ago I stirred up some controversy with an article entitled "Cisco vs. Lucent: The Flow Ratio Tells All." In that piece, I claimed that our Foolish Flow Ratio, more than any other analytical metric, tells the story of why Cisco Systems (Nasdaq: CSCO) is a better-run company than Lucent Technologies (NYSE: LU), and thus the better investment. Many retaliated that Lucent should not be judged against Cisco because of inherent business model differences between the two. Well, judge for yourself, but Lucent released its 10-Q on Friday, and its Flow Ratio just keeps getting worse -- along with its stock price.
For those of you not familiar with the Flow Ratio, it's is a simple numeric drawn from a company's balance sheet. It measures the flow of cash through a business, and tells us whether a company is doing a good job of controlling its cash. Why is this so important? Let me put it this way, cash mismanagement is to a business what clogged arteries are to a human -- potentially deadly.
The Flow Ratio is a Rule Maker original, invented by Tom Gardner back in 1997. (I don't know about you, but I remember the original epiphany.) Regular readers here know the Flow Ratio like a dear old friend, but for those of you who are scratching your head over this "Flow" concept, I encourage you to digest this explanation of the Flow Ratio (take your time -- it's time well spent, and we'll wait for ya).
OK, now we all know and understand the Flow Ratio, right? Even so, it never hurts to refamiliarize ourselves with the calculation. So, let's walk through the math behind Lucent's Flow. This is easy stuff -- four numbers, a little subtraction and division, and that's it. The four numbers we need are:
- Total cash and "near cash"
- Total current assets
- Short-term interest-bearing debt
- Total current liabilities
June 30, 2000 ASSETS ($ millions) Cash and cash equivalents......... $710 Receivables less allowances of $330 at June 30, 2000 and $318 at September 30, 1999 .. 10,101 Inventories....................... 4,936 Contracts in process, net of contract billings of $6,138 at June 30, 2000 and $5,565 at September 30, 1999............... 1,758 Deferred income taxes - net....... 1,511 Other current assets.............. 1,565 Total current assets.............. 20,581 Property, plant and equipment, net of accumulated depreciation of $6,983 at June 30, 2000 and $6,770 at September 30, 1999..... 6,621 Prepaid pension costs.............. 5,923 Capitalized software dev. costs.... 576 Goodwill and acquired technology, net of accumulated amortization of $719 at June 30, 2000 and $502 at September 30, 1999............... 8,736 Other assets....................... 3,308 Net assets of discontinued operations 595 TOTAL ASSETS....................... $46,340 LIABILITIES Accounts payable............ ..... $ 2,196 Payroll and benefit-related liabilities..................... 995 Postretirement and postemployment benefit liabilities............. 84 Debt maturing within one year..... 1,321 Other current liabilities......... 3,591 Total current liabilities......... 8,187 Postretirement and postemployment benefit liabilities............. 5,346 Long-term debt ................... 3,842 Other liabilities................. 2,835 Total liabilities ................ 20,210 SHAREOWNERS' EQUITY Preferred stock-par value $1.00 per share Authorized shares: 250,000,000 Issued and outstanding shares: none - Common stock-par value $.01 per share Authorized shares: 10,000,000,000 Issued and outstanding shares: 3,339,511,932 at June 30, 2000 3,142,537,636 at September 30, 1999 33 Additional paid-in capital......... 18,801 Guaranteed ESOP obligation......... (23) Retained earnings.................. 7,685 Accumulated other comprehensive income (loss)..................... (366) Total shareowners' equity...... ... 26,130 TOTAL LIABILITIES AND SHAREOWNERS' EQUITY............... $46,340Got those four numbers? Here's where they belong in our list:B
- Total cash and "near cash" = $710 million
- Total current assets = $20,581 million
- Short-term interest-bearing debt = $1,321 million
- Total current liabilities = $8,187 million
Flow Ratio = Current Assets - Cash Current Liabilities - Short-term Debt = 20,581 - 710 8,187 - 1,321Bad, very bad. We're looking for Flow Ratios below 1.25. From a cash perspective, a Flow Ratio of 1.0 means a company can finance all of its non-cash current assets without any extra cash investment. (Re-read that if necessary.) Lucent isn't even close. A Flow of 2.89 means Lucent is shelling out a lot of extra cash to pay for its current assets, such as inventory and uncollected payments from customers. Quite simply, Lucent's high and rising Flow Ratio is a sign of fiscal waste.
Flow Ratio = 2.89
I mentioned "rising Flow Ratio" -- yes, indeed. This marks Lucent's 11th straight quarterly increase in its Flowie. It's been a steady deterioration since late 1997, from a starting Flow of 1.47 all the way up to the current nosebleed (and cash-bleed) level of 2.89. Check out this table comparing Lucent's Flow Ratio track record to that of Cisco:
Lucent Cisco Date Flow Stock Flow Stock 12/97 1.47 $22.05 1.44 $10.51 03/98 1.56 $38.01 1.31 $12.21 06/98 1.57 $46.07 1.17 $15.96 09/98 1.69 $40.01 1.13 $18.84 12/98 1.89 $56.19 1.12 $27.89 03/99 2.03 $59.92 1.03 $28.52 06/99 2.18 $65.62 0.87 $31.06 09/99 2.26 $64.19 1.03 $44.59 12/99 2.67 $55.48 0.99 $54.75 03/00 2.80 $62.19 0.87 $69.33 08/04 2.89 $42.38 N/A $65.56 CHANGE 96.6% 92.2% -39.6% 523.8%The disparity in the stock performance of the two companies sums up the importance of the Flow Ratio. Since December 1997, a $1,000 investment in Lucent has become $1,922; in Cisco, your original $1,000 is now $6,238. An eye to the Flow Ratio at any point along the way would've steered you to the better investment.
Tomorrow, Cisco reports its fiscal year 2000 Q4 earnings. Instead of figuring out the whisper number on earnings per share, spend 10 minutes calculating its Flow Ratio using the balance sheet provided in the earnings press release. Compare it to Cisco's Flow of 0.87 in the year-ago quarter and see if the data networking gorilla is still making rules with its usual authority. We'll take a much closer look at Cisco's quarter next week.
In conclusion, Lucent's stock is already down more than 30% since my earlier article, but I still wouldn't touch it with a 10-foot pole. I'll be candid -- at the time of my earlier article in June, several Rule Maker managers were seriously considering Lucent as a short candidate. Only, only if Lucent one day shows progress on getting control of its cash management would I maybe give it investment consideration. Until that day comes, however, I consider Lucent a wait-and-see situation, and perhaps still a candidate for shorting.
Related Links:
- Matt Richey, TMFVerve on the Discussion Boards