We continue the hunt for Rule Maker software companies today. Last time, we concluded customer relationship management (CRM) software vendor Siebel Systems (Nasdaq: SEBL) was an emerging Rule Maker, but since then there's been little agreement on the company's valuation. I did my best to convince the Rule Maker managers that Siebel wasn't overvalued at its current price, but for the meantime the company remains on our watch list.

It's worth pointing out that shares of Siebel have fallen 50% since my last article, "Is Siebel Overvalued?" That only leads me to believe Siebel is an even more compelling investment idea at the new price level, but we've beat that horse to death. 

When the journey for Rule Maker software companies began last year, Zeke Ashton identified Adobe (Nasdaq: ADBE), Electronic Arts (Nasdaq: ERTS), and Intuit (Nasdaq: INTU) as the first three companies for review, citing their widespread consumer familiarity. He went on to make a case for Adobe, but the company was too expensive at the time to justify an investment.  

While Adobe remains an emerging Rule Maker, I'm eliminating Electronic Arts from any further consideration today. Sure, the company passes most of our financial and qualitative criteria, but it falls well short of controlling its value chain. For example, a shortage of Sony's (NYSE: SNE) PlayStation 2 consoles forced the video game software company to issue a profit warning earlier this year.

In the spirit of Zeke's inaugural journey, it's time to look at Intuit, which offers accounting, tax, and consumer financial software and services.

Intuit is the dominant market share leader for tax preparation, financial management, and small-business accounting software. The company's Quicken, QuickBooks, and Turbo Tax products are also market leaders. It has made a strong push to expand from packaged software to products that can be bought and used over the Internet. But before beginning a lengthy business review, let's start with our Rule Maker quantitative criteria:

Rule Maker Metrics       2000      1999
Annual Sales          $1,094M     $940M
Sales Growth              16%       36%
Gross Margin              74%       77%
Net Income              $306M     $387M
Net Margin                28%       41%
Cash-to-Debt             87.5      27.3
Flow Ratio               0.71      0.64
Cash King Margin        -8.0%      7.2%

There are plenty of financial and business model advantages -- including excellent gross and net profit margins, low Foolish Flow Ratios, and low capital expenditures -- that make software companies ideal Rule Maker candidates. As you can see in the table above, Intuit passes nearly every single one of our quantitative criteria, but its negative Cash King Margin was a surprise. With a top line of $1 billion-plus and excellent margins, that type of cash profitability -- or should I say lack thereof -- raises a big red flag.

The importance of cash has been well documented in this space. Heck, it was only yesterday Todd Lebor made his case for why Texas Instruments (NYSE: TXN) was a good company but unable to produce the amount of cash we look for in potential Rule Maker investments. Accountants are able to tweak income statements to produce additional income. Luckily, the cash flow statement prevents this type of air-brushing. More than anything, we're interested in how much money a company is making from its core business. Cash flow from operations begins to tell that story.   

I derived Intuit's Cash King Margin using the following numbers from its most recent 10-K filing:

($ millions)               2000      1999
Cash Flow From Ops.        $6.1     148.7 
Net Capital Exp.           94.9      81.3 
FCF                       (88.8)     67.4
Net Income                305.7     386.6

As you can see, there's quite a difference between Intuit's net income and cash from operations, indicating that non-operating gains were artificially boosting Intuit's net income. The non-operating culprits are easy to spot: Intuit's cash flow statement shows that the company posted nearly $579 million and $481 million in net gains from marketable securities in 1999 and 2000, respectively. 

The notes indicate that in fiscal 2000 the company sold shares of CheckFree (Nasdaq: CKFR), Homestore.com (Nasdaq: HOMS), and VeriSign (Nasdaq: VRSN). Shares of CheckFree, which Intuit acquired after selling its online banking and bill payment transaction processing business, made up the bulk of the gains.

The compelling question I ask myself before purchasing a company is this: How does this business make money? I was under the impression Intuit was a profitable company because of its successful and popular personal finance software products. After looking closer, it's evident the company has made the bulk of its money in the last two years by selling investments.

What's more, Intuit posted a pre-tax operating loss of roughly $17 million last year on sales of $1.1 billion. In 1999, it posted a pre-tax operating gain of $34 million with revenue of $940 million. For a high-margin software company, that type of operating income leads me to believe the Rule Maker Portfolio can find better software companies elsewhere. While the company does possess many of the characteristics we look for in a Rule Maker, its inability to consistently grow its core business is unacceptable.

Finally, some news from Yahoo! (Nasdaq: YHOO) Yesterday, the company shocked the financial community and the Rule Maker team with news that CEO and Chairman Tim Koogle will be relinquishing the CEO role. Equally shocking was the news that Yahoo! is reducing its fiscal 2001 earnings per share guidance from breakeven, down from the former First Call estimate of $0.36. Tomorrow, Matt Richey will offer some additional thoughts on Yahoo!'s situation.

Mike Trigg spends his spare time contemplating the merits of the Kemp-Roth tax cut and watching the Fox News show The O'Reilly Factor. To see his holdings, view his profile. The Motley Fool is investors writing for investors.