The Drip Portfolio
Being boring has its upsides and its downsides. Boring companies tend to have fairly predictable cash flows and more or less straightforward business models. They typically make boring stuff in boring factories, ship boring stuff to boring stores, and sell boring stuff to boring people. (Just kidding on that last one.) For long-term investors who are looking to become business owners over a span of decades, this kind of conservatism can be very attractive.
However, we are a little bit more demanding here in the Drip Port. We want -- better yet, we need -- some growth from our companies, boring or otherwise, in order to hit our long-range performance goals. It is for this reason that double-digit earnings growth is one of the permanent prerequisites for any investment that we make. We want dependability and growth. In other words, we want dependable growth.
Right now, IFF is not growing. Between 1994 and 1998, revenues have climbed a mere total of 7%. Meanwhile, net income has actually fallen 10%. The company has maintained good margins, respectable return on capital figures, and sizable cash flow generation, but the business is not really going anywhere.
A look at the company's cash flow statement from 1998 provides a good illustration of IFF's current predicament. The cash flow statement is one of our favorite financial statements to analyze, since it offers a window into how cash courses through a company's veins over a certain period of time. From this statement, we can quickly gain some insight into how cash is flowing in and out of the organization, like air being inhaled and exhaled.
IFF's cash flow from operations last year was $216.4 million, fairly close to its reported net income of $203.8 million. This is the money that flowed into the company from sales of its -- you guessed it -- flavors and fragrances.
What did the company do with this cash? It bought $89.7 million worth of property, plant, and equipment; it paid out $159.6 million in dividends to shareholders; and it repurchased $134.4 million of its own stock.
The math wizards out there have probably deduced that these three activities add up to more than the $216.4 million derived from operations. Where did the difference -- some $167.3 million -- come from? Sure, IFF sold some of its investments and borrowed a little bit from the bank during the year. But the bulk of the difference came from money that the company had left over in its coffers from 1997.
IFF ended 1997 with $217 million in cash and equivalents on its balance sheet. Some investors like to think of this account as the money that's sitting in a company's personal bank account. That's oversimplifying things a bit, in our minds. Companies need to maintain a certain level of available cash in order to take care of short-term funding needs as they arise during the year. In this sense, we like to think of the cash and equivalents account as the grease that keeps the wheels of the business going round and round.
Whatever your mental images of this account, it's necessary to understand that not all companies require the same level of cash on hand to keep their businesses going throughout the year. A company such as General Motors (NYSE: GM), which must wait a good period of time to see the fruit of its labors converted into cash, would probably want to keep more cash around than McDonald's (NYSE: MCD), which is turning its hamburger buns and pickles inventory into cash every time a customer buys a Big Mac.
For the food and beverage companies on our list, I've assumed that 5% of annual revenues is an acceptable level of cash to keep on the balance sheet. For the most part, the companies in our study are steady, predictable businesses in what is largely considered a mature industry. Their huge, slowly revolving wheels should not require too much grease from year to year.
In this department, IFF has seemed overly conservative recently. The firm's $217 million in cash and equivalents at the end of 1997 equaled 15% of annual revenues -- three times what we would expect to see and consistent with the levels seen in 1995 and 1996. Of course, the company faced a difficult year in 1997 and probably wanted to keep more cash on hand than it really needed in order to protect its high international business exposure from the regional economic meltdowns that were happening left and right at that time.
By the end of 1998, the level of cash on hand had been reduced to 8% of annual revenues. That's better, but it still suggests to us that the company doesn't know what to do with all the cash it generates. As dividend reinvestors, we love the sight of fat dividend checks. But as 20-year investors looking for a 15.5% annual return, we also love to see the companies we own deploying their cash in ways that will create added shareholder value down the road.
Next week, we will wrap up our look at International Flavors & Fragrances and review the third quarter results of holdings Johnson & Johnson (NYSE: JNJ) and Mellon Bank (NYSE: MEL). Until then, we'll see you on the message boards!