A few quick announcements before getting started... We were able to pick up three shares of Yahoo! (Nasdaq: YHOO) at $150 9/16 during today's intraday sell-off. Not bad compared to the eventual closing price of $167 3/8, but not timed so opportunely as to pick 'em off at today's low of $132 3/4. That would've been nice, but we're buying shares to hold for years, not minutes.
Per the usual, we paid no commission thanks to AmEx's free stock buys on accounts with more than $25K in assets. Eliminating those types of frictional costs is a key component to our strategy of outperforming the S&P 500 over the long term. If you're weighing the pros and cons of the various discount brokers, the Fool's new Discount Brokerage Center can help you sort out which one is right for you. On with tonight's report...
One of the key tenets of Rule Maker investing is that business quality is at least 100 times more important than valuation. We call it QuaVa. One method we use to evaluate the quality of a Rule Making company is to study its financial statements. Recently, I received an e-mail from George Donner, a reader in Indiana asking what it is that made Rule Maker Coca-Cola (NYSE: KO) perform so much better than Kellogg Company (NYSE: K) over the past decade.
Since it appeared that both companies could be viewed as Rule Makers from a qualitative perspective, I decided to take a closer look at the numbers. I'll have to ask you to bear with me a bit tonight, as this report will be filled with more than its share of numbers, but I think that you'll find the results interesting. Due to the companies I'm writing about tonight, you might want to print this one out and read it while eating breakfast. After all, a large glass of Minute Maid orange juice and a bowl full of Frosted Flakes seem like they'd go well with this report. With the help of our Rule Maker metrics, I think you'll see that the performance of one of these companies clearly has outshone the other over the last 10 years.
We'll start with the first line on the income statement, revenues. In 1989, Coke sold $8,622 million of beverages. In 1999, its sales had more than doubled to $19,805 million, for annualized growth of 8.67%. While that figure falls a little short of our annual revenue growth target of 10%, it's still a pretty good result. On the other hand, Kellogg's sales in 1989 were $4,652 million. Ten years later, its sales had only grown to $6,984 million, for annualized growth of a meager 4.15%.
There are a few techniques that come to mind when I think about how a company can increase its revenues. One is that it can make acquisitions of new product lines. Another is that it can sell products into new markets. It can also use marketing, advertising, or promotions to increase its sales in existing markets. Other key ingredients that are part of improving a company's business generally relate to enhancing business efficiency through such elements as new product development, investments in technology, and improved manufacturing processes.
There's one thing that each of these methods has in common -- it requires money. I think you'll see as we work our way through our other metrics that Coke's stronger financial position has given it more of the money required to make the investments necessary to grow its business.
Next, let's take a look at gross margin. In 1990, Coke's gross margin was 58.9%. In 1999, this figure was more than 18% higher at 69.7%. At Kellogg, gross margin in 1990 was 48.3%. In 1999, this figure, which peaked at 55% in 1994, was only 52.4% -- an improvement of only 8.5%. What this means is that over the last 10 years Coke's increased production efficiency has provided it with an extra 11 cents per each dollar of sales to invest in its business. Kellogg has only been able to produce an additional 4 cents per each dollar of sales over the same period. This is a big advantage for Coke.
The final feature of the income statement that we'll check in on is net margin. In 1990, Coke's net profit margin was 13.8%. This figure increased each year through 1997, when it reached 21.9%. However, Coke has struggled a bit over the last two years, and at 12.3%, its net margin is now lower than it was at the beginning of the decade. Even so, Coke still easily surpassed Kellogg's performance over this period. Kellogg's net margin was 9.7% in 1990. It now sits at a very unRule-Maker-like 4.8%. That's a pretty awful result. A look at the balance sheet should give us some explanation for what caused this setback.
Both Coke and Kellogg have taken on more debt than we typically like to see for Rule Maker companies. Last year, Coke's ratio of cash-to-debt was 0.29, well below our goal of at least 1.5x more cash than debt. Coke has long fallen below our ideal level of cash, but the current standing is at a decade low and down 50% from a ratio of 0.59 in 1990. While that's certainly not a very impressive result, Kellogg's ratio is even worse. It only surpassed Coke's current figure once during the last 10 years. Right now, Kellogg's ratio sits at a dangerously low 0.07, down from 0.15 in 1990.
One of the more impressive things about Coke's balance sheet is the ability to carry as much debt as it does, while still keeping its Flow Ratio consistently under our 1.25 target. Since 1990, Coke's Flowie improved from 1.16 to 1.04 as of last year -- a nice improvement. Kellogg's Flowie consistently comes close to our target level and has even been below 1.25 on a few occasions. But, it hasn't been able to get down to Coke's level. Kellogg's Flowie currently stands at 1.33, compared to 1.29 in 1990.
While it's not part of the Rule Maker Essential Criteria, a company's cash conversion cycle (CCC) is another good indicator of its ability to manage its working capital effectively. The CCC measures how quickly a company can take a raw material, turn it into a saleable good, sell that good, and collect the related revenues. In 1990, Coke's CCC was negative 17 days. In 1999, it had fallen to an incredibly low level of negative 125 days. During the decade, Coke improved its CCC every year except one.
The three balance sheet components of a company's CCC are accounts receivable, inventory, and accounts payable. Over the last 10 years, Coke increased its sales by 130% and its cost of sales by only 69%. What's important to note is that over this period receivables increased by only 119%, inventory by ONLY 36%, and payables by 168%. Those results are music to a Rule Maker investors ears. Essentially then, over the last decade, Coke has decreased the amount of interest-free loans that it gives to its customers, decreased the amount of cash tied up in inventory sitting on its shelves, and increased the amount of interest-free loans it gets from its suppliers in the form of accounts payable. Coke definitely gets high marks for its improved working capital management during the '90s.
Now, let's check in on Kellogg and see how it fared. In 1990, Kellogg's CCC was 45 days. Last year it was 56 days, the highest figure of the decade. While sales increased by 50% during the decade, cost of sales increased by 38%, accounts receivable by 91%, inventory by 28% and payables by only 22%. Among those, the only balance sheet figure that was positive was the slowdown in inventory growth.
Kellogg's management of its working capital has gotten worse over the last 10 years, while Coke's has improved. If Kellogg could improve its working capital management, then it likely would be able to cut down on its cash needs and start paying down its debt balance.
There's one last Rule Maker element that I'd like to look at tonight -- the Cash King Margin (CKM), or free cash flow as a percentage of sales. The performance of Kellogg's CKM has been erratic to say the least. It was 10% in 1990, 4.6% in 1992, 10.4% in 1995, and 8.1% last year. On the other hand, Coke's CKM has improved from 6.9% in 1990 to last year's 14.4%, its third-highest result during the decade.
All in all, it looks like Coke has made a clean sweep of all the criteria I looked at. Its absolute and relative performance in each category has been better than that of Kellogg. It should come as no surprise that Coke's stock has substantially outperformed Kellogg over the last 10 years as well. Between year-end 1989 and year-end 1999, Coke's stock shot up nearly 7x in value. By way of contrast, Kellogg's stock has little more than doubled over the same period.
While the recent declines in some of Coke's Rule Maker metrics -- its top management issues, the slowdown of its sales growth, and the increase in its debt levels -- leave it a little short of where we'd like it to be in Rule Maker terms today, it should be easy to see that over the last 10 years Coke has substantially outperformed Kellogg from a Rule Maker perspective.
You'll note that in performing this analysis, I never once mentioned the price-to-earnings ratio, price-to-sales ratio, or any other traditional valuation metric in comparing the two companies. This exercise provides an example of the ability of the Rule Maker Criteria to measure the value of a business as evidenced by the quality of its financial statements.
That's all that we have time for tonight. As always, if you have any questions about what I've covered tonight, we can continue the discussion over on our Rule Maker message boards.
Phil (TMFGrape on the boards)
