A New Cash-King
by Rob Landley
Austin, TX (Sep. 22, 1998) -- Big Al Levit and I have argued about Dell Computer in this column before: Is it a Cash-King company? Why? Why not!? Al argued that, though great, Dell wasn't a Cash-King, because it consistently has low gross margins. I responded, in Dell's defense, that it was a clear market leader and a great investment despite the margins, and should be listed as a Cash-King.
After a little more thought, I've come to the conclusion that we were both right.
Ordinarily, we say that if an entire industry isn't capable of generating the kind of gross and net margins that we demand, then there simply aren't any Cash-King companies in that industry. We aren't going to apologize for and excuse entire industries, if they have unremarkable operating models. We likely won't be featuring textile mills or paper recyclers in the Cash-King Portfolio any time soon. They just don't offer the public markets an inherently lucrative business model.
But some businesses, like the makers of steel-toed clodhoppers, argue that "Hey, we're doing the best you can do selling steel-toed clodhoppers. You're going to keep us out of your portfolio for doing our best?" Actually, yes, we are. Because being the best in one category is not a compelling argument for our investment. If there are seriously unattractive limits on a particular business model, why the heck continue to sell into them instead of evolving toward something more profitable? No extra-terrestrial corporate tyrant came down from on high demanding in a booming voice that, "You must manufacture and market clodhoppers. . . forever!" (Echo, echo, echo...)
We just aren't apologists for bad business models in weak industries, even if they're delivered by the industry leader. But, there are a collection of extraordinarily successful businesses that haven't met all of our Cash-King criteria. Like Dell. Or Home Depot. Or Wal-Mart. These companies have extremely lucrative business models and have done remarkably well for their investors over the past decade.
In fact, Dell is the single best performing stock in both of the original two Cash-King paper portfolios (Simpleton and MoneyHeavy) listed in the 1st Step to Cash-King Investing. However, by the current, highly specific criteria we've set out in those steps, these companies are clearly not Cash-Kings. They haven't got the margins to keep us happy. So. . . should we just ignore them and their market-obliterating returns?
I don't think so.
I consider these companies to be examples of another type of superlative business model, one which wields market-dominating power derived from a different source. To reach for a bad metaphor, I'd like to call them "Cash-Presidents." (No Monica Whatserface jokes, please.)
While traditional Cash-Kings lead in manufacturing (the inexpensive mass production of consumer products), Cash-Presidents are leaders in distribution. Rather than making some branded product for which they can charge over-high prices, Cash-Presidents sell commodity products as cheaply as possible, preferably from several different suppliers pit against each other.
For instance, Sam Walton, the founder of Wal-Mart, started with the assumption that he'd rather have a 2% profit off of a million dollars in sales than a 10% profit off a thousand dollars in sales. Coca-Cola legend, Roberto Goizueta, believed just the opposite. He felt it necessary to fight for higher margins on the sale of his branded beverages, claiming that the single most overrated aspect of business was the temptation of rising sales and razor-thin profit margins.
Much like Al and I, the two actually didn't disagree. They spoke of different models. Al and Mr. Goizueta held with the Cash-King Manufacturing Model. Mr. Walton and I held with the Cash-President Distribution Model. Run with sophistication, both have proven to be extraordinarily rewarding approaches to business.
To be sure, the entire philosophy of Cash-Presidents is diametrically opposed to the Cash-King's dedication to the high-margin sale of distinct, proprietary, unique products. Cash-Presidents look for high-volume, low margin sales of commodity stuff. Wal-Mart, for instance, effectively unbrands the stuff on its shelves, as it offers dozens of competing products per category.
You can see then that the two models actually butt heads with one another. A Cash-King company wants the advantage to be with the manufacturer. A Cash-President wants to redirect that advantage to the distributor. This doesn't mean that a Cash-President can't sell Cash-King products. Dell computers often have Intel Inside and bundled Microsoft products. And Wal-Mart sells Coke all the time. Cash-Presidents just want to offer their customers the cheapest prices available.
Let's concentrate a little bit more on Cash-Presidents for now.
Cash-Presidents focus on efficiency, high inventory turnover, and low costs. They tend to set up shop in huge warehouses, putting all of their goods out where the customers can buy them, rather than wasting time and space trying to offer boutique-style presentations of selected offerings. Ideally, Cash-Presidents want to unload product from incoming delivery trucks and distribute it directly into shoppers' carts. Inventory that comes to a complete stop while in their possession is a bad thing. If it happens with any frequency, they just stop carrying that product.
You can see that they're really involved in a ferocious inventory game, where any inventory is a sign of failure -- a failure to sell products as fast as they're obtained. If a President stockpiles any product at the end of the day, they're losing out in efficiency. A Cash-King tenet, inherent in the Flow Ratio, which very much applies to Cash-Presidents is that a warehouse full of unsold merchandise is an expensive and vulnerable liability.
I need to hammer this home.
Inventory is bad news. A company must pay to store those products. And then they may spoil, burn, get lost, stolen, or be rendered obsolete by a competing brand. Their proper value is uncertain. But 99.99% of the time, you're right if you estimate that their value is declining, by the minute. Inventory is a depreciating liability, which should make your stomach turn. It represents cash tied up in boxes that can't even earn the 6% interest of a treasury bond. Inventory is cash that you can't have, an investment showing no return.
Opposite to this, a desk full of unfilled orders is an asset, to be taken immediate advantage of. If people want your product badly enough, they'll pay for it in advance of receiving it. This is why Cash-Presidents are usually more than happy to special order anything as long as you pay for it in advance. Dell does this all the time, and literally winds up with negative amounts of inventory -- if you look at it's balance sheet from the right angle.
This drive for inventory efficiency and up-front payment gives Cash-Presidents a lower cost basis than their competitors, and they use that small margin advantage like a billy club. By running a tight ship and investing the profits back into their business, they gradually squeeze out the higher-priced competition -- the competing distributor that tried to run a Cash-King Product Model.
Once the Cash-President has achieved dominance in a niche, its low-cost focus forms the moat around its business. Although anyone can sell the exact same commodity products as they do, nobody can sell them in any quantity for less without losing money. The benefits of economies of scale have fallen to the larger distributor. When run with expertise, the Cash-President model locks out competition on price.
It also locks out competition on performance. Cash-Presidents, like Cash-Kings, have more clout than smaller companies when it comes to striking deals with their suppliers. Not only can they get their hands on products at cheaper prices through bulk ordering, they can cut additional deals as the monopoly distributor in town. Furthermore, Cash-Presidents can often convince their suppliers to carry the burden of unsold inventory. It's the product manufacturer's job to be sure they have enough in stock to meet the demand, but not so much that they'll suffer returns.
Cash-Presidents also have little or no Research and Development expenses. Their suppliers do the R&D. Darwinianly, they just pit one supplier off against another off against another off against another... and reap the benefits. The only research that these distributors do is to improve the packaging, integration, and distribution of the products from their suppliers.
Cash-Presidents also have their own brand name, and marketing helps them. Wal-Mart is known throughout America as the distributor with the lowest prices. But it also has the eventual benefit of its brand when selling its own products. Yep. By profitably partnering with select suppliers to share marketing expenses, they can sell generic brand products for 20% less on an adjacent shelf, and boost their own margins.
All of this isn't to say that there's no overlap between Cash-Kings and Cash-Presidents. But there are clear distinctions between the two. Most companies are strong in one area and weak in the other. For instance, Microsoft and Intel are classic Cash-Kings; America Online and Amazon.com are starting to look like Cash-Presidents. Both kinds of companies, to my eye, offer the potential for excellent returns. Finding the best in each category is the challenge.
There's plenty to be debated on this topic (Al, are you out there? Fools?) Exactly what criteria should be used to recognize Cash-Presidents? When does investing in them make sense? Should we just stick to Cash-Kings and ignore Presidents completely? Should we add a Cash-President like Dell to our portfolio? The Cash-King strategy board sounds to me like a good place to debate them. See you there.
Click here to enter: The Cash-King Strategy Folder
- Rob Landley (Oak)
Stock Change Bid AXP -3 13/16 81.25 CHV -1 3/16 81.06 CSCO + 5/8 62.88 KO -2 13/16 56.31 GPS - 1/8 58.88 EK -1 15/16 83.44 XON -1 1/8 67.06 GM + 1/16 57.00 INTC -1 1/16 83.56 MSFT +1 5/16 109.19 PFE +3 5/8 101.44 SGP +4 1/2 101.63 TROW + 1/32 26.66
Day Month Year History C-K (0.07%) 7.08% 5.52% 5.52% S&P 500 0.58% 7.55% 2.36% 2.36% Nasdaq 1.03% 13.25% 1.89% 1.89% Cash-King Stocks Rec'd # Security In At Now Change 2/3/98 24 Microsoft 78.27 109.19 39.50% 2/3/98 22 Pfizer 82.30 101.44 23.25% 5/1/98 37 Gap Inc. 51.09 58.88 15.24% 6/23/98 34.5 Cisco Syst 57.56 62.88 9.23% 8/21/98 22 Schering-P 95.99 101.63 5.87% 2/13/98 22 Intel 84.67 83.56 -1.31% 2/27/98 27 Coca-Cola 69.11 56.31 -18.51% 2/6/98 56 T. Rowe Pr 33.67 26.66 -20.84% 5/26/98 18 AmExpress 104.07 81.25 -21.93% Foolish Four Stocks Rec'd # Security In At Value Change 3/12/98 20 Eastman Ko 63.15 83.44 32.13% 3/12/98 20 Exxon 64.34 67.06 4.24% 3/12/98 15 Chevron 83.34 81.06 -2.74% 3/12/98 17 General Mo 72.41 57.00 -21.28% Cash-King Stocks Rec'd # Security In At Value Change 2/3/98 24 Microsoft 1878.45 2620.50 $742.05 2/3/98 22 Pfizer 1810.58 2231.63 $421.05 5/1/98 37 Gap Inc. 1890.33 2178.38 $288.05 6/23/98 34.5 Cisco Syst 1985.95 2169.19 $183.24 8/21/98 22 Schering-P 2111.7 2235.75 $124.05 2/13/98 22 Intel 1862.83 1838.38 -$24.45 2/27/98 27 Coca-Cola 1865.89 1520.44 -$345.45 2/6/98 56 T. Rowe Pr 1885.70 1492.75 -$392.95 5/26/98 18 AmExpress 1873.20 1462.50 -$410.70 Foolish Four Stocks Rec'd # Security In At Value Change 3/12/98 20 Eastman Ko 1262.95 1668.75 $405.80 3/12/98 20 Exxon 1286.70 1341.25 $54.55 3/12/98 15 Chevron 1250.14 1215.94 -$34.20 3/12/98 17 General Mo 1230.89 969.00 -$261.89 CASH $48.07 TOTAL $22992.51 *Please note: On 8/4/98 $2,000 cash was added to the
portfolio for future investment. This will be reflected
in the numbers as soon as possible.
*The year for the S&P and Nasdaq will be as of 02/03/98