By Bill Mann (TMF Otter)

ALEXANDRIA, VA (Jan. 11, 2000) -- Lost in the firestorm of my out-of-hand rejection of Qualcomm for Rule Maker status last week was the inclusion of a lesser-known company that fits the bill much better. As promised I will spend the next three columns making a Rule Maker assessment of the three companies that I would consider for investment in our portfolio. This week, we're going to look at Cable & Wireless (NYSE: CWP).

The enterprising and patient reader will have certainly recognized that the companies that we will be analyzing in the next three weeks are also, not coincidentally, NOW 50 Index components. The Rule Maker criteria and those used to identify the NOW 50 companies are quite complementary, and companies that are included in the NOW 50 list are almost certain to be valid candidates for the Rule Maker port.

Cable & Wireless? Why would we look at the second-place British telecommunications carrier? Why, indeed. Cable & Wireless is the Bob-Denard style mercenary of the telecommunications world. C&W was the first truly multinational telecommunications company, and it was laying the trail long before anyone else had figured out that international telecommunications was where the growth was. Cable & Wireless is a $40 billion holding company for its dispersed facilities in more than 70 countries around the world. For a list of Cable & Wireless properties access this link to the company's home page. Of note are C&W's holdings in Hong Kong Telecom (NYSE: HKT), Optus (Australia), C&W USA, and IDC (Japan).

Cable & Wireless has held many of these international companies for decades. Every other telecommunications company of any stature is trying through merger, acquisition, or strategic partnership to have the same type of globalized network of incumbent carriers that C&W has had in place for years. The best way to look at Cable & Wireless is this: It is a domestic carrier in the countries that make up more than 90% of all international voice and data traffic. Mature data markets? How about the U.S., Hong Kong, France, the U.K., and Japan. Growth markets? Vietnam, Thailand, Bahrain, and Russia. And in each case, C&W is a domesticated carrier. Also, in the last two years the company has bought MCI's commercial Internet services and sold off its lower-margin retail business in the U.K.

Cable & Wireless fits into a model that has proven hugely successful in other industries, that of the aggregator of dispersed properties that then get the benefit of its global operations expertise and the combined economic power of its basket of other operating companies. So while BATELCO's status as the monopoly carrier of Bahrain would not otherwise carry that much weight, as a Cable & Wireless company it has leveraged itself to become one of the most important carriers in the Middle East. Companies in other industries that have used this type of dispersed entities are Enron (NYSE: ENE), Nokia (NYSE: NOK), CMGI (Nasdaq: CMGI), and Berkshire Hathaway (NYSE: BRK.A). Not shabby company to be among.

So, let's take a look at C&W's Rule Maker criteria, shall we?

1. Dominant Brand. This would be a tall order in the regulated world of telecommunications. The only dominant brand of true stature is AT&T (NYSE: T), and that is more on a wholesale than retail basis. But C&W does play king of the hill in many of the countries it serves, either as the monopoly carrier or as the largest in deregulated markets. Also, Cable & Wireless is one of the most influential data transport companies, with large ownership positions in many of the largest undersea fiber optic cables as well as dominant or major player positions in the four largest fiber interconnect markets: New York, Tokyo, London, and Hong Kong. On a daily basis, 28% of all global Internet traffic is carried via Cable & Wireless. In other words, there is a better than one-in-four chance that C&W's networks were utilized in transporting this article from my desktop to yours. (Whether you consider this a good thing or not should not be held against C&W.)

2. Repeat Business Purchases. There may be no better model for repeat business than telecommunications. On a retail basis, international telephony and data traffic increases by some measures more than 40% per annum. Regardless of which company gives you retail service, there's a better-than-likely chance that calls to Europe or Asia transmit across networks owned in part by Cable & Wireless. The payment for this service is either paid on a settlement basis between carriers for the differential cost of the minutes of the call, or Cable & Wireless has a set-rate recurring contract with other carriers to use bandwidth it controls. Similarly, C&W pays other carriers for the same services. C&W's advantage is that it has domestic presence in so many markets that these payments result in little more than accounting transfers between related companies, while the gross revenues remain within the Cable & Wireless corporate system.

3. Convenience. As explained in the previous two items, sometimes Cable & Wireless service is so convenient that the end user has no idea that he or she has even used it. In Internet and international telephony, for many routes and destinations it would take considerable effort to AVOID using Cable & Wireless. In countries where Cable & Wireless serves as the monopoly carrier, well, it's impossible. While the company does not rest upon these market environments for its future growth, there is a margin of safety with the company knowing that it maintains a level of revenue in monopoly environments.

4. Expanding Possibilities. In 1997, countries representing 95% of all international telecommunications traffic signed onto an International Telecommunications Union agreement to deregulate their markets and open up to competition by 2002. This has set off the wide range of consolidation and strategic agreements in Europe, and will do so in Asia. Cable & Wireless, with its domesticated status in so many international markets and its unparalleled data network, will reap the benefits of these changes. Although it will lose some of its monopolies, C&W also stands to leverage its assets as a "carrier's carrier." We were given a glimpse of C&W's strategy when it announced the sale of its retail customer base in the U.K. to NTL.

5. Your Familiarity and Interest. I'm going to cop out on this and reprint what I always say here. It is this: I can't answer this one for you. This is the odd bedfellow of the qualitative factors, as it is the most subjective. With every other factor, you can choose to put on rose-colored glasses, or you may hold your nose and flush, determined that you see nothing good about the company, but there's no getting around this one. You either know Cable & Wireless and are interested in it, or you don't and are not. I personally love the telecommunications industry, and I am always looking for the potential beasts of the bunch.

6. Sales Growth of 10% Per Year. OK, first problem with C&W, and it doesn't have much to do with sales. It is this: As a U.K.-registered company, C&W does not have the same filing requirements as American companies. It only files biannual, rather than quarterly, reports. As such, the amount of information we go on is a bit thinner than what we are accustomed to. Further, the company's dispersed operations and high number of subsidiaries make this accounting more difficult. Still, the type of information the company provides is pretty thorough. We just cannot make a perfect one-to-one equation to American accounting information. For the years 1996-1999, the compound annual growth rate of sales is 10.5% for C&W and its operating subsidiaries.

7. Gross Margins of 50%. In a sense, the material costs of transporting voice or data is quite low; and thus, the gross margin is quite high, certainly ahead of our 50% hurdle. Even so, this is not the best measure for telecommunications companies, as the exact cost of goods sold (COGS) of transporting communications is difficult to quantify. You'll find that many telecom companies such as AT&T and WorldCom do not report a COGS line item on the income statement. Further, U.K. Generally Accepted Accounting Practices (GAAP) do not include cost of goods sold.

8. Net Profit Margins of at Least 7%. OK, we're back in business. C&W's net margins are outstanding, topping 11% on average over the past five years. In the past year this number stood at 10.8%, so C&W stands as a company with a solid rate of growth as well as significant net profits from operations. And as the company moves out of the retail telecommunications business in the U.K., this margin should be expected to rise.

9. Cash No Less Than 1.5x Total Debt and 10. Efficient Use of Cash (Flow Ratio Below 1.25). Remember, dear Fools, the Rule Maker LOVES cash. A company that has significant cash reserves AND excellent growth is the sign of superior management. In C&W's case, we have again a bit of a difference between U.K. reporting and U.S. reporting. In the U.S., there is a very simple line item called "Cash & Cash Equivalents" and another for the current portion of interest-bearing debt. In the U.K. it is a bit different, with a well-defined debtors and cash section, and then a current debt line item with no breakdown for the payables that are from current payables and those from the current portion of long-term debts. So we're going to look at a slightly different metric -- free cash flow (FCF) and the level of free cash flow relative to sales, which we call the FCF margin. We can look at the level of free cash flow margin, which we will measure from the cash flow statement as:

           (Net Cash  Security   Fixed Asset
             Inflow - Deposits - Investments)
FCF Margin = --------------------------------
                     Total Revenues

In fiscal year 1999 this number was 1455 / 9120 (in thousands pounds sterling), or 15.9%. This number gauges the percentage of free cash flow that was derived from annual operating activities. A total margin of 15.9% is a gauge that the company is doing a good, but not outstanding, job of creating cash from its operations.

All in all, Cable & Wireless rates outstanding marks from a qualitative standpoint, and good ones from a quantitative one. I would be singing its praises on high if I were able to make a simpler comparison to other similar companies using the same accounting principles, be they American GAAP or international GAAP. Other companies, most notably DaimlerChrysler (NYSE: DCX), do this for the benefit of their American investors, though as a company based in Germany they are not required to do so. But all in all, C&W makes a very strong case that it is in fact a Rule Maker. Question is, will it be MORE so than AT&T or Nokia?

Your input on this topic, as always, is welcome and crucial.

Tomorrow, Matt will give you the full scoop on Yahoo!'s (Nasdaq: YHOO) fourth-quarter earnings, which came in after the bell tonight ahead of analysts' estimates. For all the details, here are links to the earnings press release and conference call.

Finally, the Fool Radio crew wants to hear from you. If you'd like to discuss the AOL-Time Warner merger or pose a question to Yahoo! President and CEO Tim Koogle, please e-mail macg@fool.com with your question/comment and a daytime phone number.

Fool on!

Bill Mann
TMFOtter on the boards

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