Earlier this month, we eliminated personal finance software vendor Intuit (Nasdaq: INTU) from our search for Rule Maker software companies. Even though Intuit is the market-share leader for tax preparation, financial management, and small-business accounting software, the company fell well short of an important Rule Maker quantitative criteria: Intuit had a Cash King Margin of negative 8%.
For a high-margin software company with $1 billion-plus in revenue, that lack of cash profitability is troublesome. But it was easy to spot because there was a huge difference between its net income and cash from operations, indicating non-operating gains were boosting earnings. Intuit's cash flow statement showed the company posted nearly $579 million and $481 million in net gains from marketable securities in 1999 and 2000, respectively.
Intuit's lack of cash profitability led us to conclude the Rule Maker Portfolio could find better software companies elsewhere. The article made its way to Intuit, and CFO Greg Santora volunteered to walk us through the company's business. In particular, he gave his take on the company's core profit-generating capabilities. Below is an abridged transcript of that interview.
A conversation with Intuit CFO Greg Santora
Santora: We're very focused on operating income, not income from abnormal or onetime activities. We exclude from our results large gains or losses on marketable securities. We really believe what people want is driving revenue out of core operations. The other things are nice and they enhance the balance sheet to provide us flexibility for the future, but they're really a result of the marketplace, as opposed to driving operational execution.
TMF: In that case, give us some insight into Intuit's operating results the last couple of years.
Santora: We've increased [pro forma] operating income from about 10% of revenue in fiscal 1998 to 16% this year. We report our financials in GAAP [generally accepted accounting principles], which includes all of those onetime positives or negatives. In order to be very balanced, we exclude those gains in our operating results. If we have a gain on marketable securities, we don't use it to bolster operating EPS. On the other hand, if we have a loss, we don't incorporate it either. We really focus on our core profit-generating capabilities.
What you saw in 1999 and 2000 was the crazy markets and valuations of some equities we happened to be holding that were obtained through strategic partnerships. We saw it was time to take advantage of some of those high prices and turn them into cash in order to diversify our portfolio because we had significant positions in a handful of companies.
TMF: Why wasn't Intuit producing much cash in 1999 and 2000?
Santora: You can't generate cash without profitability. What you're starting to see now is more focus on increasing profitability, so that we can generate more free cash flow. In the last two to three years, we saw higher capital expenditures than we might need to see going forward because we were building out a lot of infrastructure for Internet initiatives. A lot of money has gone into building the infrastructure to do TurboTax on the Web, electronic tax filing, automated tax returns, and so on. There's a lot of leverage once those infrastructures are built, but the initial investments far outpace the revenues or profits those entities generate for a couple of years. You're now starting to see us in a position where profitability will turn into much more decent cash flows going forward, outside of the marketable securities.
TMF: What's a business example of your efforts for profitability and cash generation?
Santora: The loan business was on track to grow revenues -- before the decline in interest rates -- between 35% and 50%. With the decline, it's going to grow revenues in excess of 75%. We're going to generate more in profitability because we've built an infrastructure model with extremely high variable costs. As we generate more and more revenues, a disproportionate share drops to the bottom line. Payroll is another example, where revenues are going to grow in the 50% range with improved profitability of 100% year-over-year.
Intuit's emphasis on growing profits faster than sales isn't surprising, particularly considering the company recently warned of disappointing sales but maintained operating income guidance. The ability to control costs is even more important in difficult economic conditions. Strong companies must have the ability to control costs to post strong earnings regardless of top-line results. (Adobe (Nasdaq: ADBE) CEO Bruce Chizen recently talked about this in an interview with The Motley Fool.)
The good news is that the introduction of Internet-based services and software should improve Intuit's operating performance. The company's market share enables it to raise prices on its products as well. For example, Intuit is increasing the price of the Internet version of TurboTax by 50%, and electronic tax filing by 30%. These increases should also help Intuit improve its operating profits.
Leveraging its infrastructure to create internal efficiencies and raising prices on products are two ways that Intuit can increase profitability over the next several years. If those efforts prove successful, added profitability will be turned into cash, which will ultimately be reflected in an improved Cash King Margin. We'll continue monitoring those efforts, but in the meantime, I still think there are other software companies out there that would be better additions to our portfolio.