<THE RULE MAKER PORTFOLIO>
Reaching for monopoly
By Tom Gardner (TomG@fool.com)
ALEXANDRIA, VA (Feb. 25, 1999) -- It was a rumbling, bumbling, stumbling day on the market. Our stocks fell a half percent. The market fell a little more. We find ourselves racing toward the end of our thirteenth month with a seven-percentage-point lead over the S&P 500, and facing minimal tax payments -- on just our dividends -- come April 15th. We're pleased.
My article yesterday on Dell Computer drew a very active response, and I thank you for that. I'm not thankful that there was just an active response -- no, no, that would make a Dennis Rodman or Susan Powter out of The Fool. I'm not excited about the level of the response, but rather the quality of it.
I learned a good deal more about Dell's business over the last 24 hours, and I thank those who chose to courteously and thoughtfully disagree with me. That's the beauty of this public forum. And, while I still feel that, over the long haul, the machine businesses are not nearly as attractive as the inside-the-machine businesses (that is, the automobile versus the oil inside the automobile), I was nevertheless reminded by many of you that Dell has done a remarkable job of adapting to changing conditions.
I believe the industry does bear careful scrutiny, though.
Now, my consideration of Dell's business in yesterday's report and my segue to coverage of Gap's earnings report today both remind me to restate our core principles as Rule Making investors: Use our ideas here as a guide, but make up your own mind. I don't expect all of our coverage to be correct, particularly the analysis we do on companies that we have chosen NOT to invest in.
And so, the most important principle of this entire forum is that you evaluate your own situation, read and communicate with the hundreds of thousands of other members here, and ultimately, make your own determination. Use our ideas as a guide, but make up your own mind. I hope yesterday's column on Dell has you doing just this. And I hope today's report on Da Gap achieves as much.
This morning, our Rule Making retailer, Gap Inc., announced its year-end earnings. And the company made us proud to be owners. Sales were up 40%. Gross margins improved by 1.7 percentage points. Net margins climbed 0.4 percentage points. And the company's Flow Ratio fell 9.1%, to 0.84.
On the stat sheet, Gap's gross margins for the quarter were 41%. Its net margins were 10.4%. Our casual-duds company now has $9 billion in sales and is valued at $36 billion. And it closed the year with more than 2,400 stores around the world (1106 Gap, 635 GapKids, 289 Banana Republic, and 398 Old Navy
The only sign of concern on our company's financial statements is the debt our guys are racking up to expand from one street corner to the next. Today, Gap has $565 million in cash and $496 million in long-term debt. This represents a softening of their cash-to-debt ratio to 1.1 at quarter's end. A decline in this ratio is never a good thing, but I'm not terribly concerned at this point.
Because Gap's expansion has led to strong sales growth, rising margins, the repurchase of 9.5 million shares, and tighter asset management (cf. the flow ratio). And, this borrowing has taken place in a low-interest-rate environment. Gap Inc. is putting that additional cash to very good use today. So, I'm not anxious about the weakening here -- but this is an item to keep a close eye on in the quarters to come.
Now let's take a look at the numbers according to the layout of criteria in Rule Breakers, Rule Makers. Fool member Domer has expressed an interest in our laying all of the book's criteria out online. I promise to do just that. Because I'm just returning from our book tour, I haven't had a chance to rework our 11 Steps with Rob, Phil, and Al to include these new features. That will be coming soon. (You should also know that this model is ever changing, and we welcome your input.)
For now, consult your Breakers/Makers guide, or query Fools in the Rule Maker strategy folder for guidance on the criteria and scoring system.
Gap's Fourth Quarter
1) Brand (0-1 pts) Familiarity 1 Openness 1 Optimism 1 Legitimacy 1 Inevitability 1 Solitariness 1 Humor 1 Subtotal 7 2) Financial Location (0-2 pts) Mass Habit 2 Gross Margins 1 (above 40%) Net Margins 2 (above 10%) Sales Growth 2 (above 10%) Cash-to-Debt 1 (greater than 1x) Flow Ratio 2 (below 1.0) Your Interest 2 Subtotal 12 3) Direction (0-3 pts) Gross Margins 3 (rising) Net Margins 3 (rising) Shares Out. 3 (falling) Cash-to-Debt 0 (falling) Flow Ratio 2 (down less than 10%) Expansion 3 Subtotal 14After three of our ranking categories, Gap has scored an extremely strong 33 out of 39 points. Its brand loyalty, its financial standing, and the direction of its business all look terrific. From here, we run into the tricky challenge of assessing Gap versus its competitors. One of the great challenges is figuring which competitor to select for comparison.
Given that Gap is a pretty unique entity in the clothing world -- with threads for kids, babies, women, men, students, and professionals -- I've decided to compare Gap to both The Limited (NYSE: LTD) and to Abercrombie & Fitch (NYSE: ANF), and then to average the two for our final Monopoly ranking. As I outlined in the book, if you want to get a complete view of your company's position in its markets, average together the rankings of all of its competitors to assess the level of its monopoly standing.
Due to space, I've limited the comparison to just two. Here's the outcome of Gap vs. The Limited, and Gap vs. Abercrombie & Fitch.
Gap vs. Abercrombie
4) Monopoly Status (0-4 pts) Gross Margins 2 (0-5 pts higher) Net Margins 0 (lower) Cash-to-Debt 0 (lower) Fool Flow Ratio 0 (higher) Convenience 4 (easier to buy) Subtotal 6 Gap vs. The Limited 4) Monopoly Status (0-4 pts) Gross Margins 4 (5 pts+ higher) Net Margins 2 (5 pts+ higher) Cash-to-Debt 4 (25% higher) Fool Flow Ratio 4 (25% lower) Convenience 4 (easier to buy) Subtotal 18
Average the two together, and you get a Monopoly Ranking of 12. Then tag on the one point for the enjoyment of following the business, and you end up with a final score for Gap of
Rule Maker Score: 46 out of 60 points
This is quite an excellent score, and reflects an extremely fine fourth quarter from the company. Had I analyzed the business only against the larger Limited Inc., Gap would have locked down a sensational score of 52 points (marking a very strong showing over last quarter).
All in all, it was a great quarter at Da Gap.
There are two things that I've learned from Gap's 4th Quarter, 1998. First, Fools, I believe this holding represents one of the ten most sustainable businesses in the world. A true Rule Maker. And second, hey, take another look at the smaller but quite excellent Abercrombie & Fitch. They're putting up some fantastic numbers.
Tomorrow, I will be back to make a few announcements about Rule Maker services going forward, as well as the introduction of a new Fool to the team (I'd planned to do this today, but Gap spoiled that!).
Stock Change Bid AXP + 3/16 107.88 CHV + 3/16 78.50 CSCO -1 7/16 98.50 KO +1 5/8 64.50 GPS + 1/8 62.88 EK -2 1/16 66.88 XON - 38/69 67.31 GM -1 3/8 83.63 INTC -2 5/8 127.75 MSFT + 5/8 153.50 PFE -1 5/8 130.88 SGP -1 1/16 54.13 TROW - 11/16 29.88 YHOO +5 3/16 155.38
Day Month Year History R-MAKER -0.46% -3.45% 4.69% 32.47% S&P: -0.67% -2.71% 1.60% 25.76% NASDAQ: -0.54% -7.15% 6.12% 40.77% Rule Maker Stocks Rec'd # Security In At Now Change 2/3/98 24 Microsoft 78.27 153.50 96.12% 5/1/98 55 Gap Inc. 34.37 62.88 82.94% 6/23/98 34 Cisco Syst 58.41 98.50 68.63% 2/3/98 22 Pfizer 82.30 130.88 59.02% 2/13/98 22 Intel 84.67 127.75 50.87% 2/17/99 16 Yahoo Inc. 125.81 155.38 23.50% 8/21/98 44 Schering-P 47.99 54.13 12.78% 5/26/98 18 AmExpress 104.07 107.88 3.66% 2/27/98 27 Coca-Cola 69.11 64.50 -6.67% 2/6/98 56 T. Rowe Pr 33.67 29.88 -11.28% Foolish Four Stocks Rec'd # Security In At Value Change 3/12/98 17 General Mo 72.41 83.63 15.50% 3/12/98 20 Eastman Ko 63.15 66.88 5.90% 3/12/98 20 Exxon 64.34 67.31 4.63% 3/12/98 15 Chevron 83.34 78.50 -5.81% Rule Maker Stocks Rec'd # Security In At Value Change 2/3/98 24 Microsoft 1878.45 3684.00 $1805.55 5/1/98 55 Gap Inc. 1890.33 3458.13 $1567.80 6/23/98 34 Cisco Syst 1985.95 3349.00 $1363.05 2/3/98 22 Pfizer 1810.58 2879.25 $1068.67 2/13/98 22 Intel 1862.83 2810.50 $947.67 2/17/99 16 Yahoo Inc. 2013.00 2486.00 $473.00 8/21/98 44 Schering-P 2111.7 2381.50 $269.80 5/26/98 18 AmExpress 1873.20 1941.75 $68.55 2/27/98 27 Coca-Cola 1865.89 1741.50 -$124.39 2/6/98 56 T. Rowe Pr 1885.70 1673.00 -$212.70 Foolish Four Stocks Rec'd # Security In At Value Change 3/12/98 17 General Mo 1230.89 1421.63 $190.74 3/12/98 20 Eastman Ko 1262.95 1337.50 $74.55 3/12/98 20 Exxon 1286.70 1346.25 $59.55 3/12/98 15 Chevron 1250.14 1177.50 -$72.64 CASH $185.03 TOTAL $31872.53
Note: The Rule Maker Portfolio began with $20,000 on February 2, 1998, and
it adds $2,000 in cash (which is soon invested in stocks) every six months.