Drip Portfolio Report
Wednesday, September 10, 1997
by Jeff Fischer (TMF Jeff)

ALEXANDRIA, VA (Sept. 10, 1997) -- Free cash flow is the total amount of money that a company earns after paying all operating costs, subtracting any investments made in order to maintain operations. It is often regarded as a better means to measure a stock's valuation because it accounts for the company's spending on hard assets (including the implications of depreciation).

There are a few ways to determine free cash flow at COCA-COLA (NYSE: KO), depending on how you account for the company's equity holdings and capital expenditures. Dale Wettlaufer (TMF Ralegh) endorses the method that results in free cash flow of $1.7 billion over the past six months, or about $3.5 billion annualized, representing 10% year-over-year growth. The method that I believe Randy would use gives annual free cash flow of about $3.0 billion. (The two of them are arguing behind me as I write this. I think this needs to be a RealAudio debate.)

With a current market cap of $146 billion, Coke's stock trades at 42 to 48 times free cash flow. By comparison, AT&T (NYSE: T) trades at 40 times free cash flow. Would you pay a five to twenty percent premium for Coca-Cola over AT&T? I think that answer is easy. AT&T trades at 13 times earnings compared to Coca-Cola trading at 35 times earnings, but Coke's stock isn't nearly as expensive comparatively as the earnings multiples indicate.

I feel that we're getting ahead of ourselves with the Coca-Cola analysis, though. A reader on the message board wrote, "You know the business model, and that's what you want to buy," mirroring our own thoughts as this portfolio was launched. Another wrote of measuring Coca-Cola's value by the annual net increase in case sales. We've written of the stock's valuation based on earnings, sales, operating earnings, free cash flow -- but in the beginning I was only looking at the business model.

This is a twenty-year investment. We're really not trying to determine the fair value for the stock right now, believe or not. We want to buy business models that are consistently and sustainably profitable (through both operating earnings and other means), and that should continue to be so for the next twenty years. This valuation ball began to roll, though, and it's interesting, but I think that we could write about the stock's value for the next year and still be exactly where we are now.

We are buying businesses. We don't want to pay outrageous prices for them, no. But we are investing very small amounts of money, and all of the investing is spread over twenty years. It will smooth out. We do, of course, want to believe that our companies can continue to grow at market-beating paces. That's the point. After Coca-Cola's recent news and earnings estimate revisions, the questions began to form, and that's where we stand now. We want to know the business model better going forward. Randy especially questions it.

I believe that non-operating earnings are, in the end, just as valuable as operating earnings, but the weakness is that we can't guess how sustainable they are. In the end, it is the entire business that we're buying. We want to make sure that we know how it is developing currently, and we want to believe that double-digit earnings growth can be sustained. Next quarter's earnings are announced in mid-October. Currently it appears that growth at the company is slowing considerably.

So that's where we stand. Let's move on... (Geesh... Coca-Cola monopolized half the report again. No wonder it's one of the most popular message folders.)

HEALTHCARE.  Last week we learned that of our four healthcare considerations, SCHERING-PLOUGH (NYSE: SGP) has the best margins and return on equity. It has trailing sales of $6 billion, 90% of which come from pharmaceuticals. Of total sales, about 33% come from allergy and respiratory drugs, with CLARITIN being by far the most popular.

CLARITIN accounted for more than $1 billion of Schering-Plough's 1996 sales. That product will face increased competition in the next few years, as will many healthcare products both in the pharmaceutical and consumer businesses. Schering-Plough began a generic subsidiary to compete with other generic brands, and the division has helped ebb the lost market share it has experienced in some of its more expensive name brands. As for new pharmaceutical products that enjoy years of patent protection, the company spends about 13% of annual sales on research and development.

The remaining 10% of revenue derived from non-pharmaceutical business has not grown much since 1994. Sales of foot care, sun care, and over-the-counter products have, on average, remained flat. The company, aside from launching generic brands, has these divisions on the back burner when compared to the pharmaceutical business, as it should. Margins are in the pharmaceuticals. In this industry, though, we ideally want a company that is at least menially diversified and growing most or all of its business divisions. Schering-Plough is strong, but we need to consider our options.

We're going to give general overviews of the other three companies that we're considering, and then compare the four companies to one another on specifics to come to an opinion regarding which we believe will be the best overall business to buy.

PFIZER (NYSE: PFE) has a five-year goal of becoming the world's "premier research-based health care company." Pfizer was the 13th largest pharmaceutical business in the world five short years ago, and it is now the sixth. Can it be number one in five years? With $11.8 billion in trailing sales, the company plans to spend $2 billion on research and development (R&D) this year, or 17% of sales. Pfizer spends more than any of our other considerations on R&D, and yet it the second best margins, just below those of Schering-Plough.

What is Pfizer selling? We'll devote the next recap to Pfizer. Promise.

Fool on...

--Jeff Fischer