With some regret, today we're announcing our second sell ever (the first was Gap in October 2000): The Rule Maker managers are unanimous in their decision that JDS Uniphase (Nasdaq: JDSU) is not suitable for this portfolio. JDS is a leader in its industry, yes. It has lots of cash and no debt, yes. It has high gross margins and the potential for high net margins, yes. But we overpaid for a company that we didn't understand well enough.
Not only are optical components difficult to understand in and of themselves, but JDS Uniphase is the product of numerous acquisitions, which makes the company overall an even tougher nut to crack. Further, even at its much reduced valuation, the company is still priced for significant growth. Richard McCaffery summed up our thinking on the company in his Tuesday article, " Who Should Invest in JDS Uniphase?" Maybe you, if you understand the company and industry, but not us. In the next five business days we'll say good-bye to our 32 shares of JDSU.
Owning up to an investment mistake like this is never fun, but it happens to every investor at some point. Better to learn from mistakes and move on than to miss out on new opportunities while languishing in denial. We already know where we want to reallocate the proceeds from the JDS sell: mutual fund company T. Rowe Price Group (Nasdaq: TROW).
T. Rowe is what I call an off-the-beaten-path Rule Maker. Everybody looks at T. Rowe and scoffs, "That's not a Rule Maker!" No, maybe not in the sense of a blue-chip Maker like Johnson & Johnson (NYSE: JNJ), but T. Rowe has a Rule Maker business model with the potential for steady long-term value creation. What does a Rule Maker business model look like, you ask? It's one that's cash-efficient, asset-light, profit-heavy, and predictable. I believe the asset management business meets all these criteria to a T.
As a money manager, T. Rowe collects assets and earns revenue by skimming off a small percentage of those assets in the form of a fee each quarter. Two things to notice here: 1) This is a service business, and thus T. Rowe carries no inventory -- alleviating it from the potential for any $2.5 billion inventory write-downs. 2) T. Rowe's revenue collection is simply a matter of pocketing a small percentage of the assets it already holds as custodian, and thus it has no risk of default on its account receivables. These two characteristics make for a cash-efficient business.
By "asset-light" I mean that T. Rowe's business requires little in the way of capital spending on plants, equipment, or any sort of heavy machinery. Nope, managing money is a knowledge business. It's the brand, the relationships, and the money managers themselves that are the critical assets. As a result, the vast majority of T. Rowe's expenses flow through the income statement, so that what's left on the bottom line represents capital that can be reinvested in the business or distributed to shareholders through dividends or share buybacks. And as an asset-light business, T. Rowe has the potential to grow more profitable as it grows larger. For example, it doesn't cost much more to manage $50 billion than $40 billion, and the fees from those incremental assets drop straight to the bottom line.
It probably comes as no surprise that money managers rake in major cash. Even in the most recent quarter, which was a horrible quarter amidst this bear market, T. Rowe generated $85.8 million in free cash flow on $280.5 million in revenue. Divide the first number by the second and you get a Cash King Margin of 30.6%. Over the past 12 months -- a period during which almost every equity index was negative -- T. Rowe earned $236.2 million in free cash flow on $1,176.5 million in revenue -- a 20.1% Cash King Margin. That's well above our 10% minimum requirement and well above that metric for most companies period. This is a profit-heavy business, even in the worst of times.
Which brings us to predictability. If there's anything the investment community loves it's a predictable stream of steadily growing earnings. That's why pharmaceutical companies are granted premium valuations. Even in the worst of times, people will take their prescriptions, and the pharmas will grow earnings. I submit that a conservative asset management company (i.e., this doesn't include a hot-money magnet like Janus) has a similarly predictable revenue model. Over the past 12 months, T. Rowe grew revenues by 6.3% and free cash flow growth was flat. That's decent performance, in my opinion, considering the investment climate this past year.
The beauty of the mutual fund business is that there are two ways to grow assets: net inflows of new assets from customers and organic growth of existing assets. Even in tough years, at least one of these two growth drivers will typically come through. And in most years, these twin growth engines work together to produce steady, long-term revenue growth. With the aforementioned scalability, an asset management business is likely to grow earnings a bit faster than revenue through efficiencies of scale. Thus, the money management model tends to produce predictable, sustainable long-term growth.
Even so, asset management companies haven't garnered a lot of respect from Wall Street lately. T. Rowe Price produced huge returns from shareholders throughout the '90s -- up until we purchased it for this portfolio. (It figures.) In truth, the stock probably had gotten ahead of the business temporarily. But with the company now selling for 19 times trailing free cash flow -- compared to the S&P 500's 24x multiple -- I and my fellow Rule Maker managers think T. Rowe Price represents a solid value.
If by 2006 T. Rowe were to be granted a free cash flow multiple of 24 (equal to the market currently), the company would only need to grow free cash flow by 9.7% annually in order for the stock to double ( 2x/5y). That's the type of risk/reward scenario that the Rule Maker managers would prefer versus a gamble on JDS Uniphase. So, in the next five business days, we'll sell our stake in JDS and allocate the proceeds to T. Rowe Price. By the way, if you're interested in being alerted by email whenever any of The Motley Fool portfolios make a trade, we offer our All-Portfolios Trade Alert service. We recently improved this service to include a monthly email that summarizes the goings-on in each of our ports.
Matt Richey has been humbled by many an investment gone bad, and though painful at the time, he's thankful for the valuable lessons that result. Matt is co-manager of the Rule Maker Portfolio and holds no position in any of the companies mentioned today. The Motley Fool is investors writing for investors.