RULE MAKER PORTFOLIO

Rule Maker Portfolio
Ole! T. Rowe Price Back in the Ring

By Zeke Ashton (TMF Centaur) (TMF Centaur)

Important Note: Today, the Rule Maker Portfolio is joined by its newest co-manager, Zeke Ashton. After impressing us with his analysis of T. Rowe Price in August and his criteria for Mini-Makers in September, Zeke now joins us as a Fool-time Fool. For the past five years, Zeke worked as an international financial systems consultant. But now he's trading in the power suit for a belled cap. We're always looking for a few good Fools, including more writers, so if you're interested, be sure to check out jobs page at jobs.fool.com. -Matt Richey

ALEXANDRIA, VA (November 4, 1999) -- Greetings, Fools! After a long period of underperformance, T. Rowe Price (NYSE: TROW), our much-maligned Rule Makin' mutual fund holding, has finally started to move in the last couple of weeks. For now, I'll put aside my colleague Bill Mann's Monday morning rantings concerning our company's reserving of the right to issue stock options as employee incentive. Instead, I'd like to whip you into a frenzy about something else: T. Rowe's methodical, unglamorous, wonderful financial performance of the last nine months.

T. Rowe's financial reports are so uncomplicated, it's almost embarrassing. In the spirit of being disciplined about our investments, let's jump right into it and see what's there. We'll start with the balance sheet. Heck, the thing is so simple, I'll even copy the numbers right in here:

($ thousands)                          12/31/98  09/30/99
ASSETS
Cash and cash equivalents              $283,838  $390,565
Accounts receivable                     100,702   112,025
Investments in sponsored mutual funds   192,914   204,313
Other investments                        26,597    33,310
Property and equipment                  166,612   196,839
Other assets                             26,121    16,873
  Total Assets                         $796,784  $953,925

LIABILITIES AND STOCKHOLDERS' EQUITY
Liabilities
  Accounts payable & accrued exp.      $ 45,737  $ 48,051
  Accrued compensation & related costs   56,757    89,576
  Income taxes payable                   15,308    16,404
  Dividends payable                      12,012    12,010
  Debt                                       --    17,088
  Minority interests in 
    consolidated subsidiaries            52,666    69,228
      Total liabilities                 182,480   252,357
Total stockholders' equity              614,304   701,568
  Total Liabilities & Equity           $796,784  $953,925
First of all, you'll notice that T. Rowe doesn't bother sorting out current assets and current liabilities, probably because it doesn't have enough different categories of each to justify the effort. This isn't a problem; we'll just do it ourselves when we're ready to calculate the Flow Ratio.

The first thing that I notice is that cash and cash equivalents has jumped by $106.7 million in the last nine months. As Peter Lynch says, one sure sign that a company is doing well is that cash is piling up in the bank. Our company has also borrowed a little money, $17.088 million to be exact, but T. Rowe still has almost $23 in cash for every dollar of debt. This is well over our 1.5 to 1 benchmark.

As we've mentioned before, the classic Flow Ratio typically understates a mutual fund company's control of cash, since T. Rowe just deducts its fees right off the customer account balances. There isn't a lot of risk that T. Rowe won't be getting their money on time. Nevertheless, we can calculate a Flow by taking the accounts receivables of $112.025 million and dividing by the total of our current liabilities. That would be the first four line items under liabilities, which add up to $166.041 million. This yields a Flow of 0.67. If you calculate the Flow at the beginning of the year, it was 0.78, so our company is moving in the right direction on this important metric.

Note also that total assets grew from $796 million to $953 million for the nine months, which is 26% growth annually. Remember that number, because I'll be coming back to make a point later.

OK, on to the income statement. Life is lookin' pretty good here, too.
                  Three months          Nine months
                       ended                ended
                 9/30/98   9/30/99   9/30/99    9/30/99
($ thousands)
Total Revenues    218,559   259,929    651,302   751,526
Expenses          140,090   151,574    415,483   452,461
Net income         42,974    62,221    129,133   169,324
Net margin          19.7%     23.9%      19.8%     22.5%
Diluted EPS          0.33      0.48       0.99      1.31
Diluted shares    130,096   129,041    130,209   129,562
Revenues increased 19% for Q3 over last year; and for the first nine months of '99, revenues grew to $751 million, a 15.4% increase. Moreover, for the first time ever, T. Rowe is on pace to hit our Rule Maker annual revenue target of $1 billion in annual sales.

Earnings per diluted share (EPS) improved 45% for Q3 '99 over Q3 '98. (Remember, Q3 '98 was a tough quarter for mutual fund companies due to the nasty sell-off in the equities markets last year around this time.) Nonetheless, the EPS numbers for the first nine months of '99 show improvement of 32.3% over the first nine months of last year.

Net margins have jumped from under 20% for 1998 to 22.5% for the first nine months of '99 and a fabulous 23.9% in the latest quarter. Note that T. Rowe is generating a tremendous return on the assets employed in the business. Taking the net income for the nine month period ($169.3 million), and comparing it to the average assets employed in the business over that time (796 + 953 / 2 = $874.5 million) equals a 19.4% nine month return, or an annualized return of about 25.8%. I'd be quite happy with 25% returns every year! Note also that T. Rowe is growing the asset base 26% annually (you remembered this from the balance sheet review above) and then going out and generating 25% returns on those assets. That's a combination that will result in tremendous shareholder wealth over time.

Moving to the third and final financial statement, by checking out the statement of cash flows, we can see that our company continues to generate tremendous cash from the business. T. Rowe Price produced operating cash flow of $242 million in the first three quarters of '99, of which $47 million was invested in additions to property and equipment (capital expenditures). That leaves $195 million of free cash flow for the company to reinvest in the business or give back to the shareholders (hey, that's us!)

T. Rowe spent $55 million repurchasing shares, and paid out $36 million in dividends. The rest of the cash (remember that $106.7 million increase in cash that we noticed way back on the Balance Sheet?) the company added to their cash and short term investments, and can be used to fund the company's future growth.

On October 11, Standard & Poor's added T. Rowe Price to the S&P 500 index.

Not all is champagne and balloons, however. A major threat on the horizon seems to fall under the classification of "expanding possibilities." T. Rowe's major challenge is to continue to grow assets under management (hereafter referred to as AUM). Although T. Rowe has continued to grow revenues consistently, this growth has been more a case of asset appreciation as a result of a still strong bull market than a case of new money rolling in from customers. After a slow Q2, T. Rowe did pick up net inflows of $989 million in Q3. However, the market downturn in the quarter resulted in a reduction of AUM from $159.2 billion at the beginning of the latest quarter to the current 157.4 billion. T. Rowe will have to find a way to grow AUM at a faster pace if the company is to continue to show 15% annual revenue growth.

One way to achieve this is by expanding into untapped markets. In this vein, the company has invested in a Tokyo-based Japanese joint venture with partners Daiwa Securities and Sumitomo Bank. The Japanese household savings market is one of the world's biggest, but it will likely take some time to penetrate this market.

T. Rowe is also offering other fund companies' mutual funds as part of its Asset Management Account, whereby T. Rowe consolidates all of a client's mutual fund investments, regardless of whether it's a T. Rowe Price fund or not, under one umbrella. T. Rowe receives a percentage of the mutual fund fees for the processing and record-keeping. We'll be monitoring the results of these initiatives in the hopes that they result in an acceleration of new cash inflows.

As a response to Bill's article, I'm not quite as concerned as he is about the company reserving the right to issue shares as compensation so long as the company is creating sufficient shareholder value. Sure, I'd prefer if the company to just pay out cash bonuses, as those are more transparent to the investor, but I am not of the opinion that the company is trying to pull a fast one on shareholders.

I do think that T. Rowe's recent trends of rising margins, EPS growth, and slight reduction overall in diluted shares overrides the company's tendency to issue share options to employees. Bill is perfectly right to send up a warning flag, but the same warning would be equally applicable to Microsoft, Cisco, and other companies in the Rule Maker portfolio that make aggressive use of options as employee incentive. As far as I'm concerned, our companies are innocent until proven guilty. In the meantime, we're trying to get Bill to switch to decaf!

Finally, big news came out today as Pfizer (NYSE: PFE) initiated an $82 billion merger offer for Warner-Lambert (NYSE: WLA). This comes only hours after a merger agreement between Warner-Lambert and American Home Products (NYSE: AHP). The outcome is uncertain at this point, but Pfizer's offer appears to be $10 billion richer than that of AHP. Interestingly, all of these events have transpired only days after Phil Weiss' analysis of Warner-Lambert and Pfizer, which concluded that Warner-Lambert is operating its business in a much more cash efficient manner than Pfizer. For more on this unfolding story, join the discussion on the Pfizer message folder.

Until next time, y'all be Foolish!

What do you think?
Come post your thoughts about tonight's report on our Rule Maker Strategy board. Alternatively, if you have ideas, analysis, or questions about a particular Rule Maker company, take a seat at the roundtable discussion on our Rule Maker Companies board. Finally, if you're new to all this stuff, the Rule Maker Beginners board is the place to get your questions answered.


 




Rule Maker Portfolio

11/4/99 Closing Numbers
Ticker Company Dly Pr Chg Price
AXPAMER EXPRESS-11/16$146.31
CHVCHEVRON CORP-13/16$88.25
CSCOCISCO SYSTEMS-1 1/2$70.00
DPHDELPHI AUTOMOTIVE SYSTEMS-3/8$16.50
EKEASTMAN KODAK-5/16$69.25
GMGENL MOTORS13/16$69.25
GPSGAP INC-1 3/4$33.75
INTCINTEL CORP13/16$81.56
KOCOCA-COLA CO-3/16$56.69
MSFTMICROSOFT CORP-1/4$91.75
PFEPFIZER, INC-1 5/16$37.25
SGPSCHERING-PLOUGH1/16$55.00
TROWT.ROWE PRICE ASSOC3/16$36.19
XONEXXON CORPUnch.$73.00
YHOOYAHOO INC1/2$182.13

  Day Week Month Year
To Date
Since
2/2/98
Annualized
Rule Maker -.02% -1.34% -1.34% 14.83% 42.98% 22.60%
S&P 500 .57% -.02% -.02% 10.85% 39.01% 20.64%
S&P 500(DA) .57% -.02% -.02% 11.43% 40.78% 21.52%
S&P 500(DCA) n/a n/a n/a n/a 24.71% 13.41%
NASDAQ .91% 3.02% 3.02% 39.37% 88.71% 43.60%

Trade Date # Shares Ticker Cost/Share Price LT % Val Chg
6/23/9875CSCO32.865$70.00112.99%
2/3/9859MSFT49.352$91.7585.91%
2/13/9859INTC50.624$81.5661.12%
5/1/9882GPS22.708$33.7548.63%
2/17/9916YHOO126.309$182.1344.19%
5/26/9818AXP104.067$146.3140.59%
2/3/9866PFE27.433$37.2535.79%
3/12/9817GM60.399$69.2514.65%
8/21/9844SGP47.993$55.0014.60%
3/12/9820XON64.335$73.0013.47%
3/12/9820EK63.148$69.259.66%
2/3/9856TROW33.673$36.197.47%
3/12/9815CHV83.343$88.255.89%
3/12/9811DPH17.202$16.50-4.08%
2/27/9827KO69.107$56.69-17.97%

Trade Date # Shares Ticker Cost Value LT $ Val Ch
6/23/9875CSCO$2,464.86$5,250.00$2,785.14
2/3/9859MSFT$2,911.79$5,413.25$2,501.46
2/13/9859INTC$2,986.79$4,812.19$1,825.40
5/1/9882GPS$1,862.06$2,767.50$905.44
2/17/9916YHOO$2,020.95$2,914.00$893.05
5/26/9818AXP$1,873.20$2,633.63$760.43
2/3/9866PFE$1,810.58$2,458.50$647.93
8/21/9844SGP$2,111.70$2,420.00$308.30
3/12/9820XON$1,286.70$1,460.00$173.30
3/12/9817GM$1,026.78$1,177.25$150.47
2/3/9856TROW$1,885.70$2,026.50$140.80
3/12/9820EK$1,262.95$1,385.00$122.05
3/12/9815CHV$1,250.14$1,323.75$73.61
3/12/9811DPH$189.22$181.50($7.72)
2/27/9827KO$1,865.89$1,530.56($335.33)
  Cash: $135.63  
  Total: $37,889.25  


Notes
The Rule Maker Portfolio began with $20,000 on February 2, 1998, and it added $2,000 in August 1998 and February 1999. Beginning in July 1999, $500 in cash (which is soon invested in stocks) is added every month.