Fool.com: Funding from Operations: Doing It Old School[Rule Maker] March 30, 2000

RULE MAKER PORTFOLIO
Funding from Operations: Doing It Old School

By Rob Landley (TMF Oak)
March 30, 2000

I like to invest in companies that fund entirely from operations. To me, anything other than funding from operations had better be accompanied by a VERY good excuse, and a clear plan for achieving self-sufficiency as soon as possible.

There may be a few decent excuses for not funding from operations in the short term. Start-up companies often require infusions of debt financing and venture capital as kindling to get the fires of their business processes going. Alternatively, companies experiencing difficult times can throw money at a problem until the problem drowns in it. And sometimes, companies that simply can't grow fast enough to supply all the demand in their markets borrow extra money in order to grow faster. That's what Amazon.com (Nasdaq: AMZN) is doing. Financial tools for getting an advance on the corporate paycheck exist for a reason, and sometimes their use is appropriate.

Then again, Dell (Nasdaq: DELL) managed to fund its explosive growth over the past decade without going into debt. So did Home Depot (NYSE: HD). And although I'm no fan of Microsoft (Nasdaq: MSFT), that company didn't go after venture capital back when it was three college students in a hotel room writing a BASIC interpreter for the Altair. It went after revenue instead, in the form of a contract with the Altair's manufacturer. And Microsoft didn't hold its initial public offering (IPO) and enter the public markets until 10 years after its founding, by which time the company was solidly profitable. Clearly, a good excuse is not the best of all possible situations -- performance that needs no excuses trumps it.

When a company doesn't feel like funding from operations, it has two main choices. It can use its assets and future revenue stream as collateral in order to borrow money and go into debt. Or, it can dilute its ownership, both of its assets and of any future revenue it can produce, by issuing new stock. These methods raise extra cash that the business can put to good use -- but at a cost to existing investors.

All of the managers of the Rule Maker Portfolio strongly discourage irresponsible use of debt, and after the over-leveraged 1980s, debt seems to have gone somewhat out of fashion among investors and corporate management anyway. On the other hand, issuing new stock as a handy source of capital is gaining in popularity among even the largest companies, and I seem to be the only one around here bothered by this.

Call me crazy, but I think going into debt in a controlled way for a good reason with a clear plan to pay it all off might be preferable to raising the same amount of cash by selling freshly minted stock in a secondary offering. If the company has a great opportunity that it needs extra cash to take advantage of, using debt means the existing investors get all the benefits once the seed money is paid back. In contrast, selling fresh stock means someone else gets part of the benefits produced by the company, both the new benefits as well as the ones from the existing business. If the reason management wants the cash is not a good enough excuse to take on debt, why on earth are they willing to sell off chunks of the existing profitable business? Cash is nice, but sometimes not cashing in your chips can be nicer.

While enormous secondary offerings from established companies are still fairly unpopular, regularly issuing fresh stock through employee options unsupported by sufficient stock buyback programs is widely practiced. The top two companies according to market capitalization, Cisco (Nasdaq: CSCO) and Microsoft, receive billions of dollars of cash from options every year. Smaller companies like Yahoo! (Nasdaq: YHOO) and JDS Uniphase (Nasdaq: JDSU) are copying them, although as of yet they don't have the revenue to pull it off on the same scale. Encouraging employee stock ownership is one thing, but Intel (Nasdaq: INTC) does that by buying stock from the market to give its employees, not by issuing fresh stock to pay the bills. It's not the options, it's the issuing of new stock that gets me.

Conceptually, I don't see how this differs from holding a secondary offering every year. Just because the cash immediately gets either spent or deposited in the bank without being booked as revenue doesn't mean it's not a significant source of cash used to fuel the business. Cash flows from issuing stock are so significant that new analysis tools are being invented to track them. This portfolio recently introduced a new metric, the Cash King Margin, which (among other things) includes cash flows from the "stock option tax benefit" where billions of dollars of this kind of cash gets recorded each year.

Like all advanced tools, it's easy to shoot yourself in the foot with it if you rely on it too much without understanding it. Clarifying the amount of actual spendable cash a business generates by undoing accounting formalities is a laudable goal, but that's not an excuse for confusing venture capital with operational income. Understanding what the result means is at least as important as getting the right answer.

Use of this kind of newly minted stock option plan is only likely to increase, encouraged by a multibillion-dollar tax loophole. My fellow portfolio managers don't consider the stock option tax benefit a loophole (see "Some Thoughts on Stock Options"), but what else do you call using a tax-free source of cash for tax-deductible purposes? If they didn't pay taxes to get the money, but they can get a tax deduction for spending it, somebody's pulling a rabbit out of a hat somewhere. Yes, it's perfectly legal, but if it were illegal it wouldn't be a loophole, would it?

When the largest companies on the planet can make a multibillion-dollar annual profit and wind up paying almost no taxes on it, I wouldn't be entirely surprised if such a thing were to eventually attract congressional budgetary attention. But then we all know I'm strange. The other Rule Maker managers I've talked to about this think that high-tech companies have plenty of lobbying dollars to support the status quo indefinitely no matter what, and who knows, they might be right.

My main gripe with all this is that it's not funding from operations. My secondary gripe is that these companies aren't choosing to explain to their investors WHY they're not funding from operations, but instead going back to the markets for additional rounds of financing. If they held a secondary offering, they'd have to tell us what they intend to use the money for, and why reinvesting their profits isn't enough to fund their plans. If they reap cash from stock sales to employees and the resulting multibillion-dollar tax refunds, the dilution is the same, but an explanation to investors is not required.

Meanwhile, I'm voting to put this month's $500 investment into Intel, which is doing just fine and handing buckets of stock to its employees without issuing new stock to pay for it. Companies like Yahoo! and Cisco may have a great excuse for seeking extra capital to fund their hyper-growth, but Intel is funding from operations and doesn't need any excuses.

-- Oak


 




Rule Maker Portfolio

3/30/2000 Closing Numbers
Ticker Company Dly Pr Chg Price
AXPAMER EXPRESS-2 5/8$149.00
CSCOCISCO SYSTEMS-2 7/16$73.63
GPSGAP INC1/16$50.00
INTCINTEL CORP-4 7/8$127.00
JDSUJDS UNIPHASE CORP-3 1/8$116.25
KOCOCA-COLA CO11/16$48.56
MSFTMICROSOFT CORP-3 13/16$103.38
NOKNOKIA CORP ADS-9 15/16$208.06
PFEPFIZER, INC1/8$36.50
SGPSCHERING-PLOUGH1/4$37.31
TROWT.ROWE PRICE ASSOC3/4$38.31
YHOOYAHOO INC-7 9/16$169.50

  Day Week Month Year
To Date
Since
2/2/1998
Annualized
Rule Maker -2.22% -5.96% 8.20% 8.66% 86.55% 33.51%
S&P 500 -1.37% -2.59% 8.89% 1.27% 51.79% 21.34%
S&P 500(DA) -1.37% -2.59% 8.89% 1.27% 53.56% 21.99%
S&P 500(DCA) n/a n/a n/a n/a 28.12% 12.17%
NASDAQ -4.02% -10.18% -5.08% 9.55% 175.29% 59.90%

Trade Date # Shares Ticker Cost/Share Price LT % Val Chg
6/23/1998150CSCO16.432$73.63348.05%
2/17/199932YHOO63.155$169.50168.39%
2/13/199865INTC53.762$127.00136.23%
5/1/199882GPS22.708$50.00120.19%
2/3/199859MSFT49.352$103.38109.46%
5/26/199822AXP107.998$149.0037.97%
2/3/199866PFE27.433$36.5033.05%
2/15/200032JDSU100.750$116.2515.38%
2/3/199856TROW33.673$38.3113.78%
2/15/200017NOK190.000$208.069.51%
8/21/199844SGP47.993$37.31-22.25%
2/27/199827KO69.107$48.56-29.73%

Trade Date # Shares Ticker Cost Value LT $ Val Ch
6/23/1998150CSCO$2,464.86$11,043.75$8,578.89
2/13/199865INTC$3,494.54$8,255.00$4,760.46
2/17/199932YHOO$2,020.95$5,424.00$3,403.05
2/3/199859MSFT$2,911.79$6,099.13$3,187.34
5/1/199882GPS$1,862.06$4,100.00$2,237.94
5/26/199822AXP$2,375.95$3,278.00$902.05
2/3/199866PFE$1,810.58$2,409.00$598.43
2/15/200032JDSU$3,224.00$3,720.00$496.00
2/15/200017NOK$3,230.00$3,537.06$307.06
2/3/199856TROW$1,885.70$2,145.50$259.80
8/21/199844SGP$2,111.70$1,641.75($469.95)
2/27/199827KO$1,865.89$1,311.19($554.70)
  Cash: $202.57  
  Total: $53,166.94  


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.