Friday, April 03, 1998

Cash-King Portfolio Report
by Tom Gardner

ALEXANDRIA, VA (Apr. 3, 1998) -- My week of Coca-Cola Madness comes to its close today. First, here are the links back to the articles from the week gone by.

Mon. The Week in Review -- Pfizer's Viagra gets approval. Microsoft is forced to erase the Java name from its promotions of Internet Explorer. And Intel's CEO Andy Grove steps aside.

Tue. Coke, the Globe, and Growth -- Hey, can this company capitalized at $192 billion with sales of $18.9 billion and after-tax margins of a smashing 22%, continue to grow? If so, where?

Wed. Purifying Earnings -- An introduction to an unfinished work. The search for some way to bake balance sheet factors into the income statement. So skeletal that this description can't be writ in complete sentences.

Thur. Coke's Suggestion Box -- Upgrade the Web site. Promote the lemonade. Rename Fruitopia. Just say no to dividends! Here is a list of six suggestions for Coca-Cola as it works to win more beverage sales across the globe.

Today, I'll try to provide more context on the Pure Earnings calculation offered on Wednesday, as well as throw in some sample calculations.

The Cash-King Web Message Board has been bursting with some great posts about this since last Wednesday -- from Phil and Rob, as well as from DoubleEntry, rwack, Zamboni, JeanDavid, and MarkMarcellus. I just love what we've wrought in that CK folder (Disclaimer: I'm biased).

Now, to clarify a few things.

First, as with so much of my blather, this Pure Earnings calculation doesn't come from a book. It is as yet unproven, untested, totally informal. At the same time, it is borne out of surface logic. Companies should be cheered by investors for collecting their bills quickly. And they should be doubly (or some multiple of it) applauded for turning raw materials into finished goods and selling them lickety-split. Finally, we ought to be able to reflect these merits on the income statement -- since that's where First Call, Zacks, and many in the financial media keep their watch. We might end up making the markets a tad more efficient with the right equation here. But we're just getting started.

To provide just a bit more context, I think you'll find that in much of the "valuation" work in the Cash Kingdom, we're out there on a Foolish search for ways to grasp sizable pieces of the cash-flow statement and then package its most important elements for investors of all levels. It's so important for investors to judge how well their companies manage 1) the flow of moola through the business and 2) the flow of product out of the business.

But where do investors start? Given how vital capital efficiency and sunshine-law accounting are to us as investors, we have to find ways to express how important are cash flow and product flow. And as teachers and students of this game, we have to find the right language to explain this all to the entire team -- from seniors in high school to opthamologists in Brazil to mathematicians on the Internet to a gathering of NAIC investors in Chicago.

It's a challenge, but one we love.

Ok, so we're trying to find better measurements for earnings that can be communicated to everyone. Let's look at the equation, but please take it as nothing more than an early first step of ten (or more) toward revealing a mystery or two on the cash flow statement. Here's that calculation:

Pure Earnings =

Earnings - [(Receivables x 0.25) + (Inventory x 0.50)]

Here, we're penalizing reported earnings to account for the carrying costs of receivables and inventories. Why reduce the receivables penalty down to 25% of the total while only cutting the inventory penalty in half? For a few oversimplified reasons (Hey, I said this was green!).

First, inventories are a heavier version of uncollected receivables. Inventories take up space. Discounts on unattractive inventory damage gross and net margins. And even when sold, inventories can then travel inchingly into the receivables slot. "Yeah, we sold those Sleep & Snore Ernies, but we won't be able to collect payments on them for six months." Inventories are typically twice the burden of collectibles.

Second, a rule of thumb for banks is that they'll lend up to 80% of the value of outstanding receivables, but they'll only lend 50% of the value of unsold inventory. Our nation's money stores recognize that a shelved product is much more dangerous than an unpaid bill. In fact, this lending standard for banks implies that in our earnings penalty, we should reduce inventories only down to 50% of their total while taking receivables all the way down to 20% (not 25%) of their total. Whaddaya think?

Again, this is still unproven, untested, informal and changeable.

Ok, after Wednesday's and today's report, and with Q&A access on the message folder, you probably have a pretty good sense of why this thing is being developed and what it generally means. So let's run some sample calculations on the following companies: Pfizer (NYSE: PFE), Intel (Nasdaq: INTC), and Coca-Cola (NYSE: KO). And heeee-eeee-eee-re, they are!

1. Pfizer

Sales: $12.5 billion
Earnings: $2.2 billion
Shares out: 1.3 billion
EPS: $1.70

Receivables: $2.5 billion
Inventory: $1.8 billion

Pure Earnings Calculation:

a. Multiply receivables by 0.25
b. Multiply inventory by 0.5
c. $2.2 billion - ($625 mil. + $900 mil.)
d. $2.2 billion - $1.525 billion
e. $675 million

Pfizer's pure earnings come in at $675 million. If we now divide that by the 1.3 billion shares outstanding, we end up with $0.52 of Pure Earnings Per Share. We then divide Pfizer's share price of $101 7/8 by $0.52 for a Pure P/E of 195.9.

That may seem like a lot of work, but it takes about five minutes to complete. Let's look at the next one.

2. Intel

Sales: $25.1 billion
Earnings: $6.9 billion
Shares out: 1.8 billion
EPS: $3.87

Receivables: $3.4 billion
Inventory: $1.7 billion

Pure Earnings Calculation:

a. Multiply receivables by 0.25
b. Multiply inventory by 0.5
c. $6.9 billion - ($850 mil. + $850 mil.)
d. $6.9 billion - $1.7 billion
e. $5.2 billion in Pure Earnings

Then divide that $5.2 billion by the 1.8 billion of shares outstanding to come up with $2.89 of Pure Earnings Per Share. Finally, divide Intel's price of $76 3/4 by $2.89 and you end up with a Pure P/E multiple of 25.6.

3. Coca-Cola

Sales: $18.9 billion
Earnings: $4.1 billion
Shares out: 2.5 billion
EPS: $1.64

Receivables: $1.6 billion
Inventory: $960 million

Pure Earnings Calculation:

a. Multiply receivables by 0.25
b. Multiply inventory by 0.5
c. $4.1 billion - ($400 mil. + $480 mil.)
d. $4.1 billion - $880 million
e. $3.2 billion in Pure Earnings

Then divide by the 2.5 billion shares outstanding, and you come up with $1.28 of Pure Earnings Per Share. Then divide Coke's price today of $80 1/2 by $1.28 and you come up with a Pure P/E of 58.2.

Ok, so we've made these calculations and ended up with Pure P/E Ratios of 196x for Pfizer, 26x for Intel, and 58x for Coca-Cola. So what have we found? Not to put you in a foul mood heading into the weekend, but not much. In Fooldom, we've always proposed that the P/E ratio isolated is meaningless. That holds here as well. We believe the P/E has to be related to the company's earnings growth rate to make it at all useful.

Ah, but Phil Weiss identified a problem with comparing the Pure P/E to a company's growth rate. And he's right. What is the pureness of the earnings growth rate? That has to be answered. Some day.

Falling short of answering it today, I relate to you these three companies and their Pure P/Es stacked against their projected five-year growth rates.

            Pure     5-Year Est. 
              P/E     Growth Rate 
 Pfizer       196           17% 
 Intel         26           21% 
 Coke          58           17% 

And what does this tell us? Sorry to do it again, but not much without the context of many other companies inside and outside of these three separate industries.

You may be thinking now that we've come to the end of a useless report here. Numbers, no conclusions, and a lot of reading on a Friday evening. But I'd suggest to you that we're actually part of the way toward sharpening a potential measuring tool. Only part of the way, but somewhere. Let's restate what we've gained: 1) Earnings that loosely reflect the carrying costs of receivables and inventory; 2) A relationship between those purer earnings and the present value of the stock; 3) A relationship between that purer P/E and the company's loosely projected earnings growth rate.

We may not yet have much, but I do think we have a little more than the narrower traditional price-to-earnings ratio. If you're interested in this idea, it has to be improved. Therein lies the beauty of the message folder. See you there!


Stock  Change    Bid 
 CHV   -1 1/2   81.94 
 KO    -  3/4   80.44 
 EK    -1 13/16 64.56 
 XON   -  11/16 69.19 
 GM    +  1/16  67.50 
 INTC  +  3/8   76.69 
 MSFT  +1 5/8   92.94 
 PFE   +2 3/16  101.88 
 TROW  -1 1/16  71.44 
                  Day   Month    Year  History 
         C-K      -0.12%   1.25%   5.24%   5.24% 
         S&P:     +0.24%   1.90%  12.13%  12.13% 
         NASDAQ:  +0.13%   1.07%  12.25%  12.25% 
     Rec'd    #  Security     In At       Now    Change 
    2/3/98    22 Pfizer        82.30    101.88    23.79% 
    2/3/98    24 Microsoft     78.27     92.94    18.74% 
    2/27/98   27 Coca-Cola     69.11     80.44    16.40% 
    3/12/98   20 Exxon         64.34     69.19     7.54% 
    2/6/98    28 T. Rowe Pr    67.35     71.44     6.07% 
    3/12/98   20 Eastman Ko    63.15     64.56     2.24% 
    3/12/98   15 Chevron       83.34     81.94    -1.69% 
    3/12/98   17 General Mo    72.41     67.50    -6.77% 
    2/13/98   22 Intel         84.67     76.69    -9.43% 
     Rec'd    #  Security     In At     Value    Change 
    2/3/98    22 Pfizer      1810.58   2241.25   $430.67 
    2/3/98    24 Microsoft   1878.45   2230.50   $352.05 
    2/27/98   27 Coca-Cola   1865.89   2171.81   $305.92 
    2/6/98    28 T. Rowe Pr  1885.70   2000.25   $114.55 
    3/12/98   20 Exxon       1286.70   1383.75    $97.05 
    3/12/98   20 Eastman Ko  1262.95   1291.25    $28.30 
    3/12/98   15 Chevron     1250.14   1229.06   -$21.08 
    3/12/98   17 General Mo  1230.89   1147.50   -$83.39 
    2/13/98   22 Intel       1862.83   1687.13  -$175.71 
                               CASH   $5666.26 
                              TOTAL  $21048.76 
 *The year for the S&P and Nasdaq will be as of 02/03/98