Howdy, Fools! In my last article, "In Search of Rule Maker Industries," I made the statement that some industries are inherently more attractive and lend themselves to Rule Maker-caliber companies more than others. As examples of target-rich environments, I presented the key Maker stats for selected companies in two industries: pharmaceuticals and software. Both industries offer fertile ground for emerging companies to plant the seeds of future wealth.
What surprised me is that out of all the pharmaceutical companies I could think of, only one -- our own Schering-Plough (NYSE: SGP) -- was able to surpass every statistical benchmark that we use in our rankings. Of course, the others were fairly strong candidates, but out of seven leading major drug producers, I would have expected at least a couple more to have made the Rule Maker A-list.
Then, I chose the only three large software companies that popped into my mind, those being Microsoft (Nasdaq: MSFT), Oracle (Nasdaq: ORCL), and Adobe (Nasdaq: ADBE). All three easily exceeded our benchmarks in every category. This tells me that there are likely more Rule Makers (or emerging Rule Makers) out there, and that I need to increase my familiarity with this industry. Therefore, I'd like you to join me as I take a tour through the software world, occasionally stopping to examine more closely a fine specimen here and there.
Let's start by discussing gross margins. For software producers, there is a cost -- sometimes modest, oftentimes substantial -- in the initial production of the code, as well as the tough task of acquiring pioneering users. Once a critical mass of consumers has been reached, however, every additional sale ideally requires little in the way of additional production costs, so more and more of each incremental sale drops to the bottom line.
This allows dominant software companies to turn in some absolutely killer gross margins. Microsoft, for example, keeps gross margins well north of 85%. Adobe's gross margins for fiscal 1999 were over 90%. This is well above our Rule Maker benchmark of 50%, and leaves a whole lot of room for high net margins as well. Microsoft's net margin of 40.2% is one of the highest that you'll find for any company in any industry.
Then, there's the business model advantages. Because software is stored electronically, it doesn't cost much of anything to store it, and pressing a CD (or even better, distributing it electronically) means that the costs of distributing the product are minimal. This keeps the inventory line on the balance sheet down to microscopic or even nonexistent levels. For example, Adobe sold $282 million worth of software in the first quarter ended March 3, 2000, and had no inventory whatsoever on its balance sheet. Since inventories are a large component of the "bad" current assets that we plug into the numerator of our Flow Ratio calculation, not having any inventory pretty much guarantees a low Flowie.
In addition, because software companies can essentially create new copies of the product at will, companies that use electronic distribution for a large percentage of their sales can get paid first, then deliver the product later. That means they can translate their product into cash almost instantly. It also reduces the amount of accounts receivables that the company has on its balance sheet. Accounts receivables are the other major category of undesirable current assets, and by keeping accounts receivables low in addition to the inventory advantages mentioned above, companies like Microsoft can generate Flow Ratios of less than 0.40, which is so much better than our 1.25 target that it's in another league entirely.
The capital required to build the software is not usually significant when compared to, say, Intel (Nasdaq: INTC) having to build a new fab or Coca-Cola (NYSE: KO) having to build a new plant. Microsoft may need to lease a new building, buy some new workstations, and hire some new programmers, which makes software a low-capital business.
The advantages of maintaining an ultra-low Flow and the freedom from having to make large capital expenditures to build the business can be seen by looking at the statement of cash flows. Tying up assets in inventory and running high accounts receivables balances have a direct negative impact on the operating cash flow a company can generate. Software companies' minimal levels of both inventory and accounts receivables generally result in operating cash flow in excess of net income. In addition, by not having to make large capital expenditures that eat away at the operating cash, free cash flow is greatly enhanced. Because of these cash-conserving features of the industry, many software companies can post Cash King Margins that are even higher than the impressive net margins featured on their income statements.
Finally, there is the advantage for the companies that have entrenched themselves as the leaders in their given software niche that consumers want and need to have standard applications. This need for a given standard makes it very hard for a competing company to convert users to a new product once the first mover has established critical mass. For example, most companies are standardized on Microsoft's operating systems and office productivity software. It's not likely that these companies would be willing to switch to another standard unless the relative benefits were absolutely enormous.
Similarly, here at The Motley Fool we distribute all of our electronic products in Adobe's Acrobat format. For us to move to another software standard (and ask all of you, our customers, to migrate with us) would introduce some enormous switching costs. This gives Adobe a huge advantage and introduces a tremendous barrier to entry for competitors. I'll be back next Friday to continue with my software industry study.
Before I go, I'll put my dime's worth of input regarding our monthly $500 investment: Yahoo! (Nasdaq: YHOO). Like Matt, I'm positively astounded at this company's continued ability to target potentially lucrative opportunities and then go after them.
Have a great weekend, and stay Foolish!
