Microsoft's Cash Flow
I wrote about Microsoft after it released fiscal 2000 third quarter earnings last month, but the newly filed 10-Q gives us some additional detail from the cash flow statement on how business fared during the quarter. Overall, Microsoft generated $3.4 billion in free cash flow during the first three months of this year. By way of comparison, that's 25% more cash than Coca-Cola generated for all of the past year. So, Microsoft is undoubtedly producing loads of cash, but the question that must be asked is: What's the direction?
In the public markets, direction is far more important than the current location. We're always looking for companies whose operating metrics point to a sweeter future -- more cash, less debt, rising profit margins, more efficient working capital management. Those are the companies that will offer the greatest likelihood for share price appreciation. That's why we review our Rule Maker Criteria for all of our companies on a quarterly basis. In Microsoft's case, despite the $3.4 billion of cash earned during the quarter, that number represents a 7.3% decline compared to the year-ago number.
Quarterly numbers do, of course, slowly form longer-term trends, but I think this one blip in cash flow growth shouldn't cause us too much concern. For the quarter, we're still looking at unparalleled free cash profitability. The Cash King Margin rang in -- and I mean with a DONG -- at 59.9%. Let me spell that out: For every dollar in sales, Microsoft lined its coffers with nearly 60 cents in cold hard cash. It's true that the year-ago quarter saw an even more spectacular 79.5% Cash King Margin performance, but the current 59.9% CK still represents the fourth most profitable quarter since I began tracking the numbers in 1997.
Stepping back to survey the numbers from a broader time frame, Microsoft's trailing twelve month (TTM) cash flow summary breaks down as follows:
Microsoft TTM Prior TTM Growth Revenues $22.9B $18.1B 26.4% Free Cash Flow $13.0B $11.2B 15.9% Cash King Margin 56.6% 61.8% -5.2pp
Microsoft's legal picture is still the dominant wild card at play, but whenever the legal horizon clears, Microsoft's business will stand out for its fundamental strength.
Coca-Cola's Doldrums
We haven't given our beverage giant much attention of late. A quarterly checkup is definitely due. The last time I looked at Coke, in mid-December, I thought the company might've been in the midst of making a turn towards better operating numbers. Well, it looks like I was just plain wrong. The past three months were mediocre at best.
Revenues of $4.4 billion represented a slight decline (-0.2%) versus the year-ago quarter. Coke fessed up that inventory levels were too high so it reduced new sales in order to clear out those excess inventories. The flat performance for Q1 came after some optimistic-looking sales growth numbers during the second half of 1999 -- Q3 had 9.4% growth, followed by 10.6% growth in Q4.
Comparing TTM numbers, Coke's revenues have grown 6.1% over the past year. Not only is that shy of our 10% minimum sales growth hurdle, but margins have been deteriorating along the way. Gross margin for the quarter dropped to 68.2%, down more than two percentage points from the year-ago quarter. Even worse were net margins, which dropped entirely off the chart due to asset write-downs and restructuring charges. Admittedly, Coke is in the midst of a fairly significant management transition, but this quarter marked the second in a row of negative earnings.
It's hard to identify much of a silver lining in this story. Coke's Flow Ratio improved nicely, declining from 1.16 to 1.03, but this is just a by-product of the planned inventory reductions. Free cash flow for the quarter was negative. On a TTM basis, Coke's $2.7 billion in free cash flow translates to a 13.5% Cash King Margin. Not bad, but this cash generation has come with a heavy cost. Even while revenues stagnate, debt and total capital are spiraling upward.
Let's flash back to September 1997. Coca-Cola shares were trading at about $60 -- a good 15% above current levels. At that time, Coke carried $843 million in net debt (that's debt minus cash). Now, net debt stands at $4.7 billion. Debt has been steadily outgrowing cash for 10 quarters in a row. In the process of taking on all that debt, Coke's capital base has expanded from $10.3 billion in September '97 to $16.3 billion currently. That's a 60% capital expansion, a $6 billion investment in assets over the past two-and-a-half years. And the result? Revenues have essentially gone nowhere. Not good at all.
Nevertheless, Coca-Cola continues to reiterate its long-term objective for worldwide unit case volume growth of 7-8%. They've also promised 15% growth in earnings per share and "substantial levels of free cash flow." Over the next year, Coke needs to deliver in earnest upon these promises. If not, the company's Rule Making authority may fall into serious jeopardy.
Schering-Plough's Squeaky Clean Financials
Few companies have such a simple income statement and balance sheet as Schering-Plough. Our quiet drug maker just keeps cranking out consistent, steady growth. Meanwhile, the less consistent stock price has, in fact, rebounded more than 40% since its March low. Zeke reviewed the Q1 earnings results upon arrival last month, but the just-filed 10-Q gives us the balance sheet and cash flow data necessary to arrive at a more thorough conclusion on the quarter.
To review, Schering's Q1 income statement met or exceeded all of our usual growth and margin benchmarks: 10.1% revenue growth, 81.0% gross margins, and 26.1% net margins. Direction was solid as well.
The balance sheet and cash flow statement confirmed this performance. Cash is outgrowing debt, as evidenced by a cash-to-debt ratio that's improved to 2.73, up from 1.80 a year ago. (As a sidenote, Schering's balance sheet discloses no long-term debt, but there may in fact be an unspecified although relatively small amount of debt in the "other long-term liabilities" line item.) The Flow Ratio is hanging in there at 1.23, an ever-so-slight increase from 1.22 last year.
Finally, Schering generated a solid $536 million in free cash flow for the quarter. That translates to a Cash King Margin of 22.3% -- a very nice result in light of the 2.2% CK in last year's first quarter. On a TTM basis now, Schering's Cash King Margin is up to 19.5%, several percentage points higher than the 16.8% showing in the prior TTM.
As Zeke pointed out back in March -- Sherlock on the Trail of Schering-Plough -- Schering's cash flow has been a bit wobbly over the past three years, but this quarter's performance shoots down any doubts that Schering is still one of the best managed companies in the pharmaceutical sector.
Have a great night, Fools! As always, if any of the financial analysis presented here has you scratching your head, please don't hesitate to post a question on our Rule Maker Beginners discussion board.
And finally, today we picked up $500 worth of Yahoo! (Nasdaq: YHOO) -- 4 shares at $124 3/4 (with no commission) -- as promised at the end of last Tuesday's report.
- Matt Richey (TMFVerve on the boards)
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