Thursday, April 09, 1998

Cash-King Portfolio Report
Phil Weiss

TOWACO, NJ (April 9, 1998) -- Back on Tuesday, I discussed some concerns that we had about the relatively high levels of days of sales outstanding for Pfizer (NYSE: PFE). I also mentioned that, although the related interest rate was low, its short-term borrowings were on the high side. Tonight, I’m going to be so bold as to mention some of the advantages the company and its shareholders could realize if Pfizer decided to focus on better managing its receivables, inventory, and current liabilities.

What we’re really talking about here is cash management, and as a Cash-Kinger this is a concept that’s near and dear to my heart. If we think about the Flow Ratio for a second, we’ll remember that it's primarily affected by the conversion of current assets (primarily receivables and inventory) into cash as well as the ability of a company to hold off its current liabilities as long as possible (without losing business partners).

One thing we haven't mentioned yet is that, when taken together, the interplay between current assets and current liabilities makes up what is called a company’s Cash Conversion Cycle (CCC). The Cash Conversion Cycle measures the following:

1) How quickly a company can convert raw materials into finished goods.

2) How quickly this inventory can be sold to customers.

3) How quickly the company can get its customers to pay for these goods.

4) How much of a delay the company can secure to pay its suppliers for the goods that it purchases.

In many ways this is just what we’re looking at when we calculate the Flow Ratio -- current assets less cash divided by current liabilities. I don't mean to be a party pooper, but it really is essential that you understand this concept to maximize the value of a common-stock portfolio. How efficient a company is in converting stuff or services to cash is fundamental to its long-term survival.

When I reviewed Pfizer’s most recent 10-K, I decided to calculate its Cash Conversion Cycle. The flurry of new terms might startle you here, but this is another in our long list of calculations that take no more than ten minutes once you've mastered them. Here's the skinny on the Cash Conversion Cycle:

Add days of sales outstanding (DSO) to days of sales in inventory (DSI) and subtract days of payables outstanding (DPO) from this total. On Tuesday I explained that to calculate days of sales outstanding, you divide total sales by total accounts receivable. Then you divide 365 by that figure. This tells you how many days it takes a company to collect its uncollected sales.

So, when calculating the days of sales in inventory and the days of payables outstanding, you make the very same calculation -- albeit with inventory and payables, respectively. It may seem like a lot to do, but it isn't. And more importantly, once you've mastered this Cash Conversion Cycle calculation, you'll be able to peer right down into how well management is operating on their business model and how neatly your company turns its wares into moola.

This past weekend, I took a half hour and calculated Pfizer’s Cash Conversion Cycle. In 1996, it rang up to 95 days. Now in 1997, it's been stretched to 103 days. Personally, I think that this is way, way too long for an industry leader. I'll take an extreme example outside of pharmaceuticals just to prove a point. Dell Computer Corp. (Nasdaq: DELL) had a Cash Conversion Cycle in its 4th quarter of, get this, minus 5 days. If you’re interested in learning more about how Dell did this, drop by our website Cash-King message folder this weekend. I'm having trouble linking the article in here, but will do so to the folder this weekend.

Okay, this week has been full of mathematical formulas and discussions about a host of pharmaceutical products. So, now we’re going to lighten things up; we're going to appear really annoying; and we're going to offer some recommendations to Pfizer about how to improve its Cash Conversion Cycle.

Pfizer is a large company with over $12 billion in current annual sales and a balance sheet that has over $15 billion of total assets. Generally, it is larger in size than any of its customers and suppliers. It is also becoming recognized as the standout U.S. leader in the world of pharmaceuticals -- with billions of dollars spent each year on R&D and with the strongest sales force in the industry. Pfizer should take advantage of this and push its weight around more. There's an incredible value to be had out of working with Pfizer, and it should benefit from that value it creates. How so?

First off, I think Pfizer should take more time to pay off its current non-interest bearing payables. Right now it is paying these off every 22 days. Most payables are not due for at least 30 days. Pfizer should do everything possible to not pay its bills before they are actually due. It needs to institute some controls to better monitor the date goods are received versus the date the payment is actually due. I figure that it could easily take 35 days to pay off its bills without incurring any problems with their vendors.

If we hammer down the Cash Conversion Cycle (CCC) by these 13 days, we're now down to a 90-day CCC overall. Whether or not it can extend payables to 35 days is an open question. Whether it can extend them beyond 22 days is not. I'm certain it can.

Next, Pfizer should think about acquiring the same software that Dell did to obtain information about why its customers aren’t paying their bills as quickly as they should be. Based on my research of other pharmaceutical companies, for now, I think Pfizer could tighten the collection of its receivables down to the ballpark industry-leaders average of 55 days

By reducing the receivables period from 74 to 55 days, we’ve saved another 19 days on the Cash Conversion Cycle. Add the two changes together, and we're now down to a CCC of 71.

The next thing to attack is how long it takes to convert raw materials into inventory and sell the inventory to its customers. Some of Pfizer’s competitors are holding sales in inventory down to 40 days. Pfizer is hanging up around 52 days. It's time for our Cash-King hero to put the clamp down on inventory and manage it down toward that 40-day average.

If we can ring up that third cut in Pfizer’s CCC by 12 days, we're left with a Cash Conversion Cycle of 59 days, down from 103 days. That's more than 40% shorter than at present.

Now some of you are asking, "What’s the benefit of cutting Pfizer’s CCC this way?"

The first thing that I noticed was that Pfizer paid approximately $150 million in interest expenses last year. $150 million. I’m going to assume that shortening the CCC the way I suggested will reduce Pfizer’s short-term debt needs significantly. The result would be an elimination of these interest expenses by nearly 50%. That reduction would result in savings of 4 cents per share per year for the company -- no small potatoes. That might not sound like all that much, but it will certainly add up over time. If it gets going directionally on this, the long-term savings will be significantly greater.

I'm thinking I may just send my portfolio reports from this week over to Pfizer to see what they think about tightening the Cash Conversion Cycle -- hitting on all three cylinders with tighter controls on inventory, receivables, and payables. It certainly wouldn't be lobbing a protest its way. Just a suggestion. We don't like to own companies that we feel compelled to protest against. No thank you. This is just a slightly Foolish suggestion for tightening up product and cash flow to bury the costs of interest expenses. To anyone who is in regular contact with the company, feel free to raise this issue and report back to the Pfizer message folder.

Have a Foolish weekend,

Phil Weiss


Stock  Change    Bid 
 CHV   +1 1/4   80.31 
 KO    +  1/2   78.56 
 EK    +  1/8   64.06 
 XON   +  5/8   66.75 
 GM    +  7/8   67.44 
 INTC  +1 1/8   73.69 
 MSFT  +  1/16  88.94 
 PFE   +  1/2   99.25 
 TROW  +  3/4   72.25 
                  Day   Month    Year  History 
         C-K      +0.58%  -0.35%   3.58%   3.58% 
         S&P:     +0.82%   0.81%  10.92%  10.92% 
         NASDAQ:  +0.73%  -0.84%  10.12%  10.12% 
     Rec'd    #  Security     In At       Now    Change 
    2/3/98    22 Pfizer        82.30     99.25    20.60% 
    2/27/98   27 Coca-Cola     69.11     78.56    13.68% 
    2/3/98    24 Microsoft     78.27     88.94    13.63% 
    2/6/98    28 T. Rowe Pr    67.35     72.25     7.28% 
    3/12/98   20 Exxon         64.34     66.75     3.75% 
    3/12/98   20 Eastman Ko    63.15     64.06     1.45% 
    3/12/98   15 Chevron       83.34     80.31    -3.64% 
    3/12/98   17 General Mo    72.41     67.44    -6.86% 
    2/13/98   22 Intel         84.67     73.69   -12.98% 
     Rec'd    #  Security     In At     Value    Change 
    2/3/98    22 Pfizer      1810.58   2183.50   $372.92 
    2/3/98    24 Microsoft   1878.45   2134.50   $256.05 
    2/27/98   27 Coca-Cola   1865.89   2121.19   $255.30 
    2/6/98    28 T. Rowe Pr  1885.70   2023.00   $137.30 
    3/12/98   20 Exxon       1286.70   1335.00    $48.30 
    3/12/98   20 Eastman Ko  1262.95   1281.25    $18.30 
    3/12/98   15 Chevron     1250.14   1204.69   -$45.45 
    3/12/98   17 General Mo  1230.89   1146.44   -$84.45 
    2/13/98   22 Intel       1862.83   1621.13  -$241.71 
                               CASH   $5666.26 
                              TOTAL  $20716.95 
 *The year for the S&P and Nasdaq will be as of 02/03/98