Looking at the numbers behind Tellabs' (Nasdaq: TLAB) business is easier than understanding its myriad of telecommunication connection equipment. Or so I thought. Below are the Rule Maker quantitative criteria and how Tellabs stacks up (numbers for the year ended December 2000):
Tellabs RM Target Revenue Growth 43.3% >10% Gross Margins 54.1% >50% Net Margins 22.7% >10% Cash-to-Debt 358.70 >1.5 Flow Ratio 3.15 <1.25 Cash King Margin 6.3% >10%
Worth noting is that revenue growth of 43.3% is not based on the GAAP (generally accepted accounting principles) financials reported in the annual report and 10-K but rather on restated revenue due to the Securities and Exchange Commission's Staff Accounting Bulletin No 101 (SAB 101) regarding revenue recognition. Tellabs restated revenue from $3,387.4 million to $3,328.6 million -- a $58.8 million reduction -- that resulted in a cumulative effect of change in accounting of $0.07 less per share. This restatement was not due to an incorrect revenue recognition policy but rather the adoption of a new policy.
The numbers look appetizing until you get to the Foolish Flow Ratio and Cash King Margin (CKM). A standing ovation goes out for the strong revenue growth, gross and net margins, and cash position, but let's take a look at the problem children. A Flowie north of 3.00 is nasty, and the CKM was down 50% from 15.2% in 1999 to 6.3%. What's going on over there in Chicago?
Looking over the last eight quarters, the Flow Ratio -- a measure of how well a company manages its working capital -- rose from 2.55 to 3.15. Two strikes here. The Flowie is trending up (the lower the Flowie, the better) and it is well above our 1.25 target. (The Maker Port took a look at Tellabs back in 1998 and was worried about the Flowie back then also.) We need to see some significant improvement here before Tellabs gets the nod for working capital management.
Beside this negative trend in the Flow Ratio, the CKM has dipped well below our target of 10%. Perhaps even more worrisome is that it dropped so drastically. Picking up on the reason why makes me proud to be a Fool. Before we go farther, it helps to review the CKM formula.
CKM = (Cash Flow From Operations - Capital Expenditures) / Revenues
Tellabs' cash flow from operations remained constant from 1999 to 2000 while capital expenditures more than doubled. At the same time, revenues grew only 43%. Therefore, the numerator shrank while the denominator grew and the result is a lower CKM. Everyday investors may disregard this is as a capital-intensive year, but the fact that cash flow from operations remained flat while revenue and net income soared smells of managed earnings. This, too, requires further investigation.
By digging deeper into the Management's Discussion and Analysis (MD&A) section of the 2000 annual report, we find that Tellabs is building a new headquarters in the Chicago suburb of Naperville. This development cost the company $50 million in cash last year. That $50 million is included in capital expenditures (capex) and unless Tellabs plans to build a new headquarters every year, we can back that amount out of capex in our CKM calculation. This yields a revised CKM of 7.9% -- still below our target.
Another disconcerting number is inventory growth of 130.5%. When inventory growth outpaces revenue growth, a company is not selling goods as fast as it is making them. Temporary imbalances are to be expected, but inventory growth three times that of revenue growth definitely raises eyebrows.
There can be several reasons for this, and the MD&A section provides an explanation. It states that "The overall growth in inventories was necessary to ensure that component parts with longer lead times are available to support anticipated demand, new product introductions, and field trials." Not the best explanation, but Joan Ryan, Tellabs' CFO, elaborated (when asked) during the Q4 earnings call. She stated that the five new products launched during the year and the expensive components, specifically lasers, for the TITAN 6700 optical switch produced abnormally high inventory levels.
Sounds reasonable. That said, assuming these new products start flying off the shelves in 2001, inventory levels should return to normal. This Fool will be watching.
Valuation
At $45 per share, Tellabs is only trading at a forward P/E of 22, as so many readers were quick to point out after last week's column. But its price-to-free cash flow (P/FCF) is what worries me. With approximately $270 million in FCF in 2000 (after adjusting up for the $50 million non-recurring headquarters hit), Tellabs is trading at 70x trailing FCF. Too rich for my blood and definitely not sustainable even for an industry-leading company in a high-growth market.
Eventually growth rates will slow (ahem, like now) and the share price will correct toward a more reasonable multiple. That's why we use the three-step valuation process detailed in our Art of Rule Maker seminar. Surprisingly, Tellabs is not out of range based on this analysis, but it must be firing on all cylinders and execute perfectly to satisfy our target.
Management is quite juiced when it comes to the future of Tellabs. They are gunning for the "30/30 Club" -- 30% top-line revenue growth and 30% bottom-line earnings growth. With 38 consecutive quarters of year-over-year revenue growth, Tellabs management has demonstrated that it can maintain and manage high growth. But is the growth there for the taking? That's the $36 billion question.
In order to achieve a double in five years (2x/5y), Tellabs' current market capitalization must go from $18 billion to $36 billion by 2006. Using a $270 million FCF base and applying a more reasonable, yet premium, P/FCF multiple of 35x to 2006 FCF, Tellabs needs to grow free cash flow at a 32% annualized rate.
Based on the disconnect between net income growth and FCF growth over the last year, this looks doubtful. Also, given the current telecommunications and networking slowdown, hitting growth targets this year will be extremely difficult, effectively pushing back the time it takes to build up FCF. Last, even the 32% growth needed is above management's target, thereby requiring Tellabs to execute perfectly to make 2x/5y.
Sorry, guys. Love the new digs in Naperville, but this Fool is staying on the sidelines until the convergence of telecommunications equipment pans out and visibility returns.
Todd Lebor is a co-manager for the Rule Maker Portfolio and used to live in Chicago in a department store. He does not own shares in Tellabs. Todd's other holdings can be found online, along with the Fool's complete disclosure policy.
