Rule Maker Portfolio
Mini-Makers, Part 2 of 2

By Zeke Ashton (TMF Centaur)

ZURICH, SWITZERLAND (Sept. 16, 1999) -- Hey Fools! In yesterday's column, I introduced Company X, a software company that I billed as an equal to mighty Microsoft. I demonstrated with a head-to-head comparison the extraordinary quality of Company X as a business, only to later divulge that even though the company could pass for Microsoft's evil twin brother under the microscope of the Rule Maker criteria, it's actually only about 1/1000 of Microsoft's size -- which means that if you placed the company next to Microsoft, you'd need that microscope to find it.

Proving that quality is more important than size, Company X has produced a stock price return of 919.9% over the past five years, amazingly close to the 1089.7% return that Microsoft has amassed over the same time period. Company X is Exhibit A in my argument that a small company that features awesome Rule Maker metrics such as high gross and net profit margins, a low Flow Ratio, and a high cash-to-debt ratio is as likely to produce market-beating investment returns as a large company with those same qualities.

For this reason, I dubbed Company X a Mini-Rule Maker. For a Foolish investor who already houses a full stable of industry gorillas in his or her portfolio, taking advantage of the opportunity to add a Mini-Maker can add a little extra growth potential to a Rule Making portfolio. As an added bonus, this extra growth can often be purchased at a sizable discount to the hefty price tags normally carried by our well-known titans.

How is a Rule Makin' Fool to identify these little gems? I say, use what you already know. Without further ado, I humbly offer my suggestions for a Mini-Maker checklist. I'll use Company X as my guinea pig for the first run through. Before I get started, though, I am getting a little weary of referring to this little dynamo as Company X. The company's real name is... (drumroll please)... Timberline Software (Nasdaq: TMBS).

The Fool ballcap goes to "cybersol" for being the first to identify the company. Hats off to our entire community on the Rule Maker Strategy board who by midnight had unanimously concluded that Timberline was the mysterious Company X.

Timberline is a major supplier of project-accounting and cost-estimating software for the construction and property management industries. In fact, it pretty much dominates this market. Timberline has a market capitalization of only $162 million but has grown earnings at at least a 25% clip for the past seven straight years. Timberline's five-year compounded earnings per share (EPS) growth of 47% places it fifth among all the companies in the Nasdaq over the past five years.*

In any case, we'll have plenty of opportunities to learn more about this amazing little company as we subject it to the Mini-Maker checklist. (As a disclaimer, let me state at the outset that I am not making an investment recommendation here; Fools should do their own research and make their own decisions. Investors looking at smaller-sized companies should also be aware that these companies are riskier investments than our standard Rule Makers.)

I hereby present my modified Rule Maker checklist for small companies: The Mini-Maker 9.

1) Gross Margins of 50% or Greater

It's a key factor for Rule Makers. I can't think of any reason why it wouldn't apply here. Timberline's revenues in the quarter ending in June 1999 were $13.3 million. Cost of revenue and customer support equaled $3.8 million. Gross margin is therefore 71.2% for the quarter.

2) Net Margins of 10% or Greater

In order to raise the bar a bit for our smaller companies, we'll demand that they produce an after-tax profit margin of at least 10%. In the most recent quarter, Timberline posted net income of $2.25 million on a revenue base of $13.3 million, which translates into a 17% net margin.

3) Sales Growth of 20% or Greater Than the Previous Year

Companies the size of Timberline shouldn't have a problem reaching the Rule Maker standard of 10% annual growth. However, the 25% dictated by the Foolish 8 is one that likely cannot be sustained by even the best of companies over a long period of time. I think doubling the minimum growth required of Rule Makers is a fair compromise. Total revenue for Timberline grew 26.9% in the most recent quarter versus the same quarter a year ago.

4) Earnings Per Share Growth of 25% or Greater Than the Previous Year

The Foolish 8 dictates a minimum of 25% EPS growth year-over-year. As quality companies should normally find ways to improve profitability as sales grow, I have no hesitation about expecting a true Mini-Maker to be able to squeeze out a minimum 25% EPS growth year-over-year. Timberline meets this target as well, increasing EPS 38.9% from Q2 '98 to Q2 '99.

5) A Cash-to-Debt Ratio of 3.0 or Better

One of the arguments often made against smaller companies is that they don't have the same access to cheap debt funding as do larger companies, and that a temporary cash shortage could have nasty implications for a small company that finds itself without easy access to capital. To account for this extra risk, I will double the minimum ratio of cash-to-debt for our Mini-Rule Makers to 3.0, with no debt preferable.

Timberline paid off all it's interest-bearing debt during the second quarter, and had just over $13 million in cash and investments, or an entire quarter's worth of sales, as of June 30.

6) Foolish Flow Ratio of Under 1.25

Because we demand only the best, companies with Flowies over 1.25 need not apply. This is Timberline's single most impressive stat, rivaling Microsoft for microscopic Flows. Timberline's Flow in the most recent quarter was 0.39.

7) Positive Cash Flow From Operations

One of the Foolish 8 criteria, and a very applicable one for our baby Cash-Kings. Timberline produced 75 cents per diluted share of operating cash flow in the first six months of 1999, and has consistently generated very strong cash flow from operations.

8) Strong Historical Performance

As far as past five-year performance goes, Timberline may not be in a class by itself, but it doesn't take long to call the roll. Timberline has produced a five-year compounded EPS growth of 46.9%; a $10,000 investment in September 1994 would be worth $91,900 today, not including dividends.

9) The Leader in Its Chosen Market

Sure, Timberline doesn't have 90% of the global PC operating software market like Microsoft does, but it's definitely the dominant player in the construction and property management software market. The great thing about a niche market is that owning a market of smaller size creates a huge barrier to entry. Potential software competitors like PeopleSoft or SAP are much more likely to go after Siebel Systems in the larger (and hotly contested) enterprise software market.

Competing against an entrenched leader like Timberline in a limited market just isn't an economical proposition for competitors. In fact, it generally works the other way. The fact that the software bruisers ignore this market allows Timberline to make further inroads and stretch their traditional market by adding complementary products. I'd like to present an excerpt from Timberline's latest 10-Q concerning their position in their chosen market:

"Continued strength in the construction industry and the increasing dominance of our products in our targeted markets were the primary factors contributing to the increase in software sales, which rose 28% in the second quarter.

"In July, we released a 'quickbill' enhancement to our Billing module as we broadened our market to address the needs of the specialty contractors. Also in July, we announced our intention to offer software for the construction project management market. The addition of project management software combined with our expertise in the accounting and estimating software areas will allow us to offer a fully integrated software solution to the construction market."

I've read a lot of SEC filings in my time, but I have few recollections of a company, especially one of Timberline's usual low-key nature, coming right out and announcing dominance in a market. (Of course, Microsoft could never get away with it, as asserting dominance in their SEC filing would be tantamount to inviting the Department of Justice over for milk and cookies.) As you can see, Timberline keeps right on adding pieces to the default software solution for these markets.

Gosh, looks like I'm out of space already. Let's hear your comments about my Mini-Maker checklist on the Rule Maker Strategy board.

Until next time, y'all stay Foolish!

*The source of this data is, which offers a stock screen that ranks Nasdaq companies. To qualify, the company must have had a minimum 25% EPS growth over the latest 12 months, minimum 25% EPS growth last quarter versus same year-ago quarter, a minimum five-year growth rate of 25%, and increasing EPS for the last five years. In addition, the companies must have a closing price above $12 and must not have had a loss in any of the last five years. Sounds like some tough criteria, huh? Just in case you are wondering, only 23 Nasdaq-traded companies qualified for this list. Of the qualifiers, Dell was ranked number one, and Microsoft ranked number eight.