Friday, March 06, 1998

Cash-King Portfolio Report
by Tom Gardner (

ALEXANDRIA, VA (Mar. 6, 1998) -- The Cash-King Portfolio chugged ahead with all five stocks up today. On Monday, we'll be announcing the purchase of our Foolish-Four stocks, which will come with a twist. Tune in for an interesting report then. Then next week, Phil Weiss will be back -- so you can expect to hear a bit more about Pfizer (perhaps something about their new drugs) and about the Duke basketball team, since Phil is a rabid fan.

It being Friday, we dedicate this Cash-King portfolio report to financial instruction. Before I jump right into my discourse today on What Sort of Large Company Isn't a Cash-King, I'd like to thank all of you who sent and posted notes about my Beardstown Ladies column yesterday.

Smiling Synic on the Web was the one Fool out there who thought I was too lenient on the Ladies. A slew of notes ran contrary to his. Tammy Allen-Schenke wrote a pretty inspiring note about learning how to invest via a mix of ideas taken "from The Beardstown Ladies, Peter Lynch and The Motley Fool." She concluded with:

I now shutter at the stupidity of blindly turning all these decisions over to someone else whom we perceived to be superior at looking out for our own best interest...

It may be that those most disturbed by the average Joe's direct access to the hallowed grounds of finance are those who have profited for decades on the average American's ignorance in these matters.

Another Fool, Jeb Sturmer, added that it's this push for better financial education among the people that's inspired him to purchase, mat, and frame a single share of Coca-Cola for his 11-year-old son on his birthday (I hope he's not reading this report, Jeb!). Then, Dave Sinclair chimed in that he enjoyed yesterday's coverage of the Beardstown Ladies enough to confess that he's spending more time each day in Fooldom than he does reading The Wall Street Journal (which has been a habit of his for thirty years).

A final and very valuable note came from Mark Robertson, the Chicago Council Director of the National Association of Investors Corporation (NAIC). Mark offered corrections to two incorrect assumptions I made in yesterday's report. He made these two points:

  1. "Membership fees" are infusions of capital, far from an expense as intimated in your discussion.

  2. Very few investment clubs incorporate. In fact, most form as general partnerships, and the fees and reporting requirements are nominal. Most clubs have small monthly capital infusions, and the club is more about a pooling of resources and ideas than it is about large volumes of money.

Mark emphasized in his note that until America rigorously scrutinizes the performance of our financial institutions and mutual funds, few of us should be too critical of the Beardstown Ladies. Mark closed his note with a letter submitted to Fortune Magazine in which he wrote:

Beardstowner Betty Sinnock recently delivered a tearful explanation and rebuttal to an audience of NAIC investors. It was a powerful reminder of the human being side of this. These ladies are human, and it's possible that a mistake was made. It's also feasible that the actual return will still exceed the S&P 500... and you know what, it might not be all that far from 23.4%.

Thanks for the note, Mark.

And that brings to a close yesterday's report on the audit and performance restatement oncoming from the Beardstown Ladies. If you have additional questions or comments about the article, please drop by our Cash-King Message Folder.

Now, on to Friday's Financial Lesson.

In speaking and writing about the Cash-King approach to the markets, I'm sometimes asked, "Are you just suggesting that we buy really big, familiar companies and hold them for the long haul?" The answer there is certainly no.

Over the past ten years, a great number of multi-billion-dollar public companies have underperformed the market's total return. Touching the industries of metal, media, technology, and retailing, familiar names like Bethlehem Steel, Dow Jones, Apple, and Kmart have dramatically underperformed the market since 1988.

Today, I'd like to take a look at one of those companies, Kmart (NYSE: KM), and see whether it meets our basic Cash-King criteria.

Kmart is the nation's #3 retailer, behind Wal-Mart and Sears. The company sells clothing, appliances, furniture, and toys directly to consumers through its 2,200 discount stores throughout the United States. So, this is a consumer brand that most of us are familiar with and that plenty of Americans repeatedly buy from. Thus, Kmart meets our general qualitative aims.

Let's look at the company's financials. Through the nine months of this fiscal year, Kmart is sporting these stats on its income statement:

 Total Sales      $22.4 billion 
 Gross Profit      $4.9 billion 
 Gross Margin      21.9% 
 Net Income       $63   million 
 Net Margin         2.8% 
 Market Cap        $7.8 billion 

On the income statement, Kmart meets two of our criteria. It has more than $1 billion in total sales and it's capitalized above $5 billion. Beyond that, Kmart falls well short.

As Cash-King investors, we search for companies with gross margins above 50%, an achievement that indicates light up-front, material costs to the business. And we look for companies with greater than 7% net profit margins, meaning that 7 cents in after-tax profit is made on every $1 of sales. These are companies whose operations are turning over substantial profits to shareholders each year.

So, Kmart falls well short on two of our four income-statement requisites. It's difficult to imagine a scenario where we'd invest in the company, given its operational results, but let's take a look at Kmart's balance sheet through nine months of the fiscal year and stack it up against the CK criteria:

Cash & Equivalents    $280 million 
 Long-Term Debt        $2.3 billion 
 Current Assets        $9.2 billion 
 Current Liabilities   $4.3 billion 

Here again, not surprisingly, Kmart falls short. On the balance sheet, we look for a company with Cash & Equivalents ringing in at more than 1.5x long-term debt. In Kmart's case, the company has 8.2x more long-term debt than cash. This business is exposed. Over the next year, it'll be paying out about as much in interest payments on that debt as it has cash in the bank today.

Second, we look at our Foolish Flow Ratio, outlined in the Seventh Step to Cash-King Investing: QuaVa and The Flow Ratio. We subtract cash from current assets and divide that figure by current liabilities, hoping for a magic number below 1.25 (ideally, below 1.00). We want those current assets (inventories and receivables) held in check. And we'd like to see payments due over the next year to be rising, which indicates that the company is putting its short-term monies to use. In Kmart's case, we subtract $280 million (cash) from $9.2 billion (current assets) then divide that by $4.3 billion (current liabilities).

Tap-tap. Click, click, click. Zing. Buzzzzzzzzzzz!

Kmart's flow ratio is 2.07, over two times removed from our ideal. Not good. The problem for the company is the $7.8 billion in merchandise inventories. Kmart is being forced to carry a huge load of unsold products from one month to the next. For a company with $30 billion in annual sales and gross margins below 25%, Kmart -- with $7.8 billion in product sitting on their shelves -- is doing a dismal job of turning over its inventory. Its Flow Ratio is unacceptable.

It isn't likely that Kmart will qualify for the Cash-King Portfolio. Let's look back over the eight measurements we've made today:

Consumer brand             Yes 
 Repeat purchase            Yes 
 Sales of $1 billion+       Yes 
 Market-cap of $5 billion+  Yes 
 Gross margins of 50%+       No 
 Net margins of 7%+          No 
 Cash equaling 1.5x debt     No 
 Flow ratio below 1.25       No 

On the four key financial requirements, Kmart falls short, by large margins. Looking back at historical performance, over the past ten years, Kmart's stock has reflected this financial "unsturdiness." The stock has moved from $17 in 1988 to $27 in 1992 back to $15 3/4 here in 1998. That's 10-year total growth of negative 7.3% during a period that the S&P 500 has risen four times in value.

Yes, the company is trying to turn itself around, having sold off its international stores. And Kmart just brought in Charlie's Angel Jaclyn Smith as well as Elmo, Kathy Ireland and Martha Stewart to breathe some life into its stores. A lot can be learned about Kmart's progress by following its quarterly financial results. Kmart may end up being a market-beating large company over the next ten years, if it can radically change directions -- tightening inventory controls, paying down debt, and gaining power over suppliers. But it's in too unstable a position today for us to be interested.

So to answer again to the initial question -- no, we don't believe that all large consumer-franchise stocks are buys-and-holds for the long haul.

Have a great weekend, Fools. See you in the Cash-King Folder, and if you've missed any of our last five weeks of articles here, you can read through them via this link: Past Cash-King Portfolio Columns

Tom Gardner


Stock  Change    Bid 
 KO     +  9/16   69.31 
 INTC -10 15/16   75.50 
 MSFT   -2 1/4    80.00 
 PFE    +  9/16   85.56 
 TROW   -1 7/8    67.00 
                  Day   Month    Year  History 
         C-K      +1.07%  -1.13%   0.61%   0.61% 
         S&P:     +1.99%   0.61%   5.43%   5.43% 
         NASDAQ:  +2.43%  -0.96%   6.09%   6.09% 
     Rec'd    #  Security     In At       Now    Change 
    2/3/98    24 Microsoft     78.27     82.69     5.65% 
    2/3/98    22 Pfizer        82.30     86.25     4.80% 
    2/27/98   27 Coca-Cola     69.11     70.50     2.02% 
    2/6/98    28 T. Rowe Pr    67.35     68.63     1.90% 
    2/13/98   22 Intel         84.67     78.06    -7.81% 
     Rec'd    #  Security     In At     Value    Change 
    2/27/98   27 Coca-Cola   1865.89   1903.50    $37.61 
    2/3/98    24 Microsoft   1878.45   1984.50   $106.05 
    2/3/98    22 Pfizer      1810.58   1897.50    $86.92 
    2/6/98    28 T. Rowe Pr  1885.70   1921.50    $35.80 
    2/13/98   22 Intel       1862.83   1717.38  -$145.46 
                               CASH  $10696.94 
                              TOTAL  $20121.32 
 *The year for the S&P and Nasdaq will be as of 02/03/98