Thursday, April 16, 1998

Cash-King Portfolio Report
Al Levit

Glendale, CA (Apr. 16, 1998) -- In yesterday's report, I described how I went in search of non-tech Cash-King companies with the aim of digging out 16% annual growth for 10 years. It was tough to find any. The projected growth rates of large companies outside of the tightly defined technology industry are tough to find. So I went to bed last night, tossing and turning, waking up, rubbing my temples, trying to get back to sleep, and all the while agonizing over the possible lack of attractive Cash-King investments at these valuations.

What was there to do? In times of torment when investing, I turn back to profit margins.

So this morning, I shook myself awake, raced to the latest copy of Fortune magazine (the Fortune 500 issue, which truly is spectacular), and I studied the fourteen Fortune 500 companies in the pharmaceuticals industry. I mean, gimme a break, Fools. What great businesses! We're talking research, development, and then the mass production of tiny little pills that get sold for top dollar. What a business model! Start with scientific scholarship and follow it with the development of high-priced, repeatedly purchase, pin-sized products. That's a Cash-King investor's dream.

I flipped through the numbers on these companies, then clicked back online for the rest of the data and back to where my Cash-King buddy, Phil Weiss, could provide me feedback on my ideas. Naturally, the first pharmaceutical company I looked at was Pfizer (NYSE: PFE), our Cash-King stalwart -- up more than 18% for us since we purchased it in early February.

Along with Pfizer, I studied four other pharmaceutical companies: Abbott Laboratories (NYSE: ABT), Merck (NYSE: MRK), Warner-Lambert (NYSE: WLA) and Schering-Plough (NYSE: SGP). Here are some figures for your Foolish fancy (AOL users, please expand the window to view this table):

                     PFE  ABT    MRK    WLA   SGP 
 Stock Price          $99  $76    $126  $176   $82 
 Market Cap (bill.)  $128  $58    $150   $56   $60 
 P/E on trailing EPS 57.9x 28.9x  33.7x  55.4x 41.7x 
 P/E on '98 Est. EPS 49.0x 28.0x  28.7x  41.9x 35.9x 
 P/E on '99 Est. EPS 40.7x 24.8x  24.9x  33.6x 31.0x 
 Est. 5-Yr Growth    17.1% 12.7%  14.2%  20.1% 14.6% 
 Gross Margins     86%   64%    54%     74%    84% 
 Net Margins       18%   17%    20%     11%    21% 
 Cash (millions)   $877  $230   $1,125  $773   $714 
 Cash-to-Debt      1.2x  0.25x   0.84x  0.42x  15.5x 
 Flow Ratio        1.12  0.96    1.27   0.97    0.76 

Note: The Average P/E ratio for these five companies over the past 10 years is 30x earnings.

Holy cow, what a terrific business model, eh? All five of these companies are running very high gross and net margins, attractive flow ratios, and strong historical and projected growth rates.

In addition to just marveling at the industry, I played around with some of these numbers. I focused intently on the companies' earnings growth rates and that 10-year average P/E multiple of 30x earnings. Here's what I came up with. If Pfizer were to grow at its projected 17% per year for ten years and were to trade at that 30x earnings then, the stock would be priced at $294 per share on January 1, 2009.

Via the same assumptions, Abbott -- with a projected growth rate of 12.7% -- in ten years would trade at $270. Merck, with 14.2% projected annual growth, would trade at $496. Warner Lambert, with 20.1% projected yearly growth, would be priced at $785 per share. And Schering-Plough, with 14.6% estimated annual growth, would be trading at $268.

And from their present prices, off those simplified assumptions, here's the potential yearly growth rate performance of the stocks:

  • Warner-Lambert: + 16.1%

  • Merck: + 14.7%

  • Abbott: + 13.5%

  • Schering-Plough: + 12.6%

  • Pfizer: + 11.5%

I should note that these figures ignore the compounding of dividends. But we're pursuing an inexact general view of the industry and present valuations. Factoring in the dividends wouldn't change things materially.

Interestingly enough, the winner of this footrace was Warner-Lambert, a company we haven't discussed much in the Cash-King world. It may not be a household name, but many of its products are. Warner Lambert sells products like Actifed and Sudafed, Certs breath mints, Listerine mouthwash, Schick razors, and Rolaids antacids. The company also makes Parke-Davis prescription products.

Clearly, though, Warner has at least one major problem with being a Cash-King -- its high levels of long-term debt. At present, Warner's cash comes in at only 42% of its long-term debt in a world where we look for businesses with 150% more cash than debt. Further, Warner's debt comes in at 22% of revenues and 65% of equity.

Now, the company does seem to be managing the payments on this debt aggressively, normally getting arrangements with banks for the best prevailing rate. If one can look past the debt -- and that is a big If -- then the Cash-King credentials shine through. Warner has high margins, a strong growth rate, and a flow ratio below 1.00, as well as very nice products and cash management.

When I compare Warner-Lambert to our Cash-King selection, Pfizer, I actually find a couple of points in Warner-Lambert's favor:

  1. I personally like it that Warner's business expands past the pharmaceutical line. There is always more risk when a business is concentrated in one area, especially if it is a non-consumer area (you must be a physician to prescribe a prescription drug). Warner-Lambert's over- the-counter drug business gives it considerably more consumer exposure than Pfizer has. Those of you who follow the Drip portfolio may recall that this was one reason that Johnson and Johnson (NYSE: JNJ) was chosen over Pfizer and Schering-Plough. In selecting J&J, the Drip managers sacrificed growth. But with Warner-Lambert, the growth rate is there -- the question is, can it methodically knock off the debt?

  2. Warner seems to manage its product flow and its collectibles a little better than does Pfizer.

Make no mistake about it, though, under ordinary circumstances I would find Warner-Lambert's debt quite unattractive. And I'd fall in love with Pfizer's cash position, its gross margins of 86%, and its net margins of 18%. (In discussion, Phil Weiss has reminded me of that repeatedly.) But currently, I don't think that circumstances are ordinary.

Pfizer has just had a dynamite drug approved, and everybody seems to know about it and wants it in their portfolio. As a result, its stock price is way above the historical multiples for the group. The great question is: Will Pfizer outgrow its projected earnings growth, while continuing to strengthen its balance sheet? If so, the stock is undervalued even here. But if not, the degree to which it does not outperform expectations will determine how far down the list of these five pharmaceuticals falls Pfizer (phooey!)... alliteration!

Now, it's most important to restate that our motto in Cash-King investing is that quality is more important than valuation, maybe 10 times more important, maybe 1,000 times more important, depending on your investing time horizon. In that context, I believe that both Pfizer and Warner-Lambert are high-quality companies in a great industry that will be around for a long time to come.

In fact, take another look at the stalwarts above. Merck has a billion dollars in cash. Pfizer has those gross margins of 86%. Abbott is trading under 30 times earnings. Warner-Lambert has a projected earnings growth rate above 20% per year. And Schering-Plough has a flow ratio of 0.76 (Pfizer, take note of this!). Each of these companies has a unique strength, and most (if not all) of these companies, to my eye, will beat the market for many, many years to come.

But will they outperform the after-tax returns of the RP-4 model going forward? Only time will tell, Fools. I don't know about you, but I'll find it tremendously fun to watch this develop over the next decade, and the one after that -- and if we do reverse the aging process of cells, maybe for 10 or 12 more decades after that.

For now, I'm happy that we've already made the 18% in our investment in Pfizer. But if I didn't own Pfizer, I'd be looking to either broaden my exposure in technology (a company like Cisco comes to mind), or I'd be taking a closer look at Warner-Lambert, or I'd be looking to expand my exposure to the RP-4 model. DoubleEntry wrote a fine post about this on the Web message boards this evening, check it out.

And thus ends two days of heavy duty Cash-King analysis. I hope you enjoyed it. I look forward to exploring this more in the message boards. Tomorrow, blessedly, we'll be so close to the weekend that I'll lighten things up a bit as I share a method I've developed to get cold-calling brokers to hang up on YOU!!

And it's all printable!

Until then... Fool on!



Stock  Change    Bid 
 CHV   +3 11/16 83.75 
 KO    -1 7/8   74.81 
 EK    -  1/4   71.69 
 XON   +2 3/16  70.88 
 GM    -1       70.13 
 INTC  -  9/16  74.31 
 MSFT  +  3/8   91.69 
 PFE   +2 7/8   100.63 
 TROW  +2 1/2   73.25 
                  Day   Month    Year  History 
         C-K      +0.75%   1.43%   5.43%   5.43% 
         S&P:     -1.00%   0.58%  10.67%  10.67% 
         NASDAQ:  -0.27%   1.23%  12.42%  12.42% 
     Rec'd    #  Security     In At       Now    Change 
    2/3/98    22 Pfizer        82.30    100.63    22.27% 
    2/3/98    24 Microsoft     78.27     91.69    17.14% 
    3/12/98   20 Eastman Ko    63.15     71.69    13.52% 
    3/12/98   20 Exxon         64.34     70.88    10.17% 
    2/6/98    28 T. Rowe Pr    67.35     73.25     8.77% 
    2/27/98   27 Coca-Cola     69.11     74.81     8.26% 
    3/12/98   15 Chevron       83.34     83.75     0.49% 
    3/12/98   17 General Mo    72.41     70.13    -3.15% 
    2/13/98   22 Intel         84.67     74.31   -12.24% 
     Rec'd    #  Security     In At     Value    Change 
    2/3/98    22 Pfizer      1810.58   2213.75   $403.17 
    2/3/98    24 Microsoft   1878.45   2200.50   $322.05 
    3/12/98   20 Eastman Ko  1262.95   1433.75   $170.80 
    2/6/98    28 T. Rowe Pr  1885.70   2051.00   $165.30 
    2/27/98   27 Coca-Cola   1865.89   2019.94   $154.05 
    3/12/98   20 Exxon       1286.70   1417.50   $130.80 
    3/12/98   15 Chevron     1250.14   1256.25     $6.11 
    3/12/98   17 General Mo  1230.89   1192.13   -$38.77 
    2/13/98   22 Intel       1862.83   1634.88  -$227.96 
                               CASH   $5666.26 
                              TOTAL  $21085.95 
 *The year for the S&P and Nasdaq will be as of 02/03/98