Let's play a little game. Below is a side-by-side comparison of two well-known Rule Makers, who I'll refer to simply as Company Y and Company Z. These companies have a lot in common: a global presence, a strong brand, a superb long-term track record of share price appreciation, and a shared home within our portfolio. Here's a hint: Both deal in a "soft" industry. One last commonality worth noting is their valuation. Both are priced at 42x trailing free cash flow. And yet, that's where the similarities end. As you will see below, one company is clearly superior.
Here's how the two stack up on our five core RM criteria:
Company Y Company Z Sales Growth 6.0% 24.7% Gross Margin 69.2% 87.0% Cash King Margin 14.3% 60.6% Net Cash -$4.4B 17.8B Flow Ratio 1.04 0.40
Glance down the list and you'll see that it's really no comparison at all, but rather a study in contrasts. Company Z is growing sales four times faster than its counterpart. And those sales are more valuable for Company Z because of its superior profitability, as indicated by its higher gross margin and its nosebleed-level Cash King Margin (more on that later). Same goes for the balance sheet, where Company Z is rolling in the dough, while Company Y is awash in debt. And finally, Company Z's lower flow ratio reveals working capital management that's more than twice as efficient as that of Company Y.
Yep, it's the king of soft drinks versus the king of software: Coca-Cola (NYSE: KO) versus Microsoft (Nasdaq: MSFT). And Microsoft (Nasdaq: MSFT) dominates in every respect. Yet, as mentioned earlier, these companies are valued identically on a free cash flow basis. Amazing, isn't it? But let's dig deeper.
There are some definite conclusions to be drawn from this information, but before I delve into those, I want to pause for a quick refresher on free cash flow. (This may not be "the pause that refreshes," but it could be the pause that enriches.) For those unfamiliar, free cash flow can be thought of as "cash profits." The calculation for free cash flow is operating cash flow less net capital expenditures. (See the link above for an explanation and example.) It's like net income on the income statement, except we're dealing with profits as measured on the cash flows statement. Cash profitability is what counts. Cash is king.
In case you hadn't noticed, here in the Rule Maker, we have an all-out love affair with cash. In fact, free cash flow is the basis behind our latest toy, the Cash King Margin. Have you seen this nifty little metric? Quite simply, it tells us how much cash a company makes for each dollar of sales. In that way, it's like the standard net profit margin except we're dealing in cash reality instead of accounting fiction.
As you can see in the table above, Coca-Cola has a CK Margin of 14.3%. Thus, Coca-Cola earns 14.3 cents in free cash flow for each dollar of sales. Not bad -- that's meaningfully above our 10% hurdle. But that ain't nothin' compared to Microsoft's 60.6% result, which happens to be the highest Cash King Margin I've personally encountered. Just ponder this number for a moment -- Microsoft keeps 60.6 cents for every dollar worth of software it sells. Profitability of that magnitude is a sure sign of Rule-Making authority.
Interestingly enough, I only recently examined the numbers and realized how profitable Microsoft really is. You see, Phil and I have previously talked between ourselves about how Microsoft is unique in the way it records its tax benefit from employee stock options. As you might recall, the cash flows statement has three sections: operating, investing, and financing. Microsoft -- unlike Cisco, Intel, and Yahoo! -- accounts for its stock option tax benefit in the financing section of its cash flows statement, whereas the convention is to include this in the operating section, which is where I think this item belongs. My rationale is as follows: The tax benefit arises from the form of compensation used (options), and since compensation is an operating expense, I think a tax benefit associated with compensation should be accounted for as operating cash flow. And apparently, except for Microsoft, our other tech Rule Makers concur.
Okay, that was a bit tedious, but here's the bottom-line: Microsoft's stock option tax benefit during calendar 1999 amounts to $4.5 billion. This ain't peanuts, folks! In fact, adding this amount to the company's stated operating cash flow of $9.4 billion results in total adjusted operating cash flow of almost $14 billion. That's a 48% boost over the stated amount. Let me be clear, this adjustment is necessary in order to compare free cash flow on an apples-to-apples basis with the likes of Cisco, Intel, and Yahoo! By this new perspective, Microsoft is far-and-away the most profitable company in our portfolio. And yet, amazingly enough, the company is valued at the same price-to-free cash flow multiple as our portfolio's dog, Coca-Cola.
What does this mean? I think it's a matter of the predictability of Coke versus the expanding possibilities of Microsoft. Coke's predictability as a business is almost unparalleled in the corporate universe. Nobody doubts that 100 years from now Coca-Cola will still be selling beverages worldwide. The market knows this and has priced the shares accordingly.
The market seems to put a premium on predictability, while it consistently undervalues expanding possibilities (as well as the value of cash flow over earnings). Will Microsoft be around in 100 years? Your guess is as good as mine, but I think chances are good Microsoft will be around in some form or another. As the king of software, Microsoft has almost unlimited new ventures it could eventually address. How about Coke? Other than beverages, what could they do? They tried movies in the 1980s -- and failed. As an investor, I'll give up predictability any day in favor of expanding possibilities and business quality on the level seen in Microsoft. At an equal price, the risk/reward tilts strongly in favor of Microsoft.