Last week, we started fleshing out the report card concept for looking at Rule Maker companies. This week, I will give the beginnings of an example, really focusing on the qualitative side. Next week, I will build out and describe some discounted cash flows and show a report on a company that, while a Rule Maker, fails on its report card. I had intended to condense this into a single article, but have found that each of these items takes a little bit more description than I had anticipated. I hope you will pardon the serial nature of these columns, but I do want to make sure to fully and clearly impart the notion that this is not a mechanical strategy and as such requires some noodle work. At the same time, I will try to keep this as simple as possible.
Again, in the spirit of the Rule Maker Strategy's new policies, we'd like to be able to use this framework on a large number of companies, very few of which are, or will ever be, in the "official" portfolio. Those of you who have stuck with us for the past few months (or years) have heard this before, but because this conversation is being engaged by thousands of new people each week, I will repeat it once again (and again and again): We do not consider the components of the Rule Maker Portfolio to be some sort of comprehensive list of Rule Makers. In fact, there are likely to be a good 200 American and international companies that would meet the qualitative test of Rule Maker status. We cannot and will not own them all.
Matt Richey and I are putting together a list of companies that would comply on the qualitative side for Rule Maker status that we'll release soon. Call it a "universe," and that's what portfolio strategies try to achieve: to eliminate a large number of the 10,000 public companies from investment consideration. Analyzing companies can be a time-consuming process -- the culling process is an inevitable necessity for people endeavoring to invest in individual equities.
I recommend that anyone unclear about this and what we're trying to accomplish refer to the article "Portfolio Shake Up" from January 2002. One more piece of housekeeping: We are almost done with the revamp of the Maker, so I'd like to thank you for your input, your patience, and your forbearance. I'd particularly like to thank a few Fools who have played sounding board for me: MDawgX, Stringcheesemark, PhilWeiss, ZenvestorB, andrewychan, badsin Padavona, TMFBogey, TMFTomG, TMFCentaur, and TMFMatt. I'd also like to thank my parents for making me possible. Sorry, Oscars overload. Is that damn show over yet?
Let's get down to business and look at a company. I'm going to start with Costco (Nasdaq: COST) to give you an idea of what a full report might look like. You should also think about ways that you would want to customize it in order to make the report card more useful to you. Also, go and grab the most recent Costco 10-K.
Before we even look at the numbers, though, let's talk about the sustainability of Costco's competitive advantage. Costco's own description of its business suffices quite well:
"We operate membership warehouses based on the concept that offering members very low prices on a limited selection of nationally branded and selected private label products in a wide range of merchandise categories will produce high sales volumes and rapid inventory turnover. This rapid inventory turnover, when combined with the operating efficiencies achieved by volume purchasing, efficient distribution, and reduced handling of merchandise in no-frills, self-service warehouse facilities, enables us to operate profitably at significantly lower gross margins than traditional wholesalers, discount retailers, and supermarkets. "
In other words, Costco's competitive advantage is centered upon its ability to buy in enormous bulk, consolidate, and sell in its big-box stores. Sounds pretty similar to the model that makes Wal-Mart (NYSE: WMT) tick, except that in the case of Costco, there are far fewer individual stock-keeping units (SKUs) than at Wal-Mart. More similar are Wal-Mart's Sam's Club and BJ's Wholesale Club (NYSE: BJ), both of which are significantly smaller than Costco. Costco maintains only marginal advantage over these two companies in terms of concept and pricing, but among the three they have conquered the U.S. market. Costco's larger membership base also provides some advantage.
With few exceptions, there are no companies possessing the same purchasing power as Costco. Their no-frills megastores (135,000 square feet on average) require minimal capital reinvestment, and the company's method of inventory management means that in many cases, it has negative sales cycles. It has sold goods out of its inventory even before it has paid suppliers. The capital required to make a concentrated assault on Costco's market by anyone other than BJ's or Sam's Club (or Aldi and Carrefour internationally) would be immense.
Still, if we were to use a company's own words as proof of dominance, then every company on the face of the planet would fit our criteria. So let's back this up with a look at our Rule Maker criteria. For each item, I will answer the question and then fill in background information as needed.
10-year Cash King Margin averaging 10%. No. For the last two years, Costco has burned cash from operations rather than creating it. However, in each of the last five years, the company has increased its number of stores by more than 8%, with even more rapid increases in the last two years of 10% plus. The company funds nearly all of its additional stores from cash flow, with minimal dependence upon debt.
10 years of revenue growth. Yes. Compound Average Growth Rate for the period exceeds 10%.
Consistent profitability. Yes. Both operating profits and operating cash flow have been positive for every year of operation.
Honest, shareholder-centered management. Yes. Costco's financial presentation is clear and concise, written in something that approximates very closely to the English language. No member of senior management is paid more than $500,000 in base, and the company's annual stock options compensation program falls well below 2% of total share float, with only a small portion (6.1%) of these options going to senior management. Additionally, there have been no repricing or canceling of out-of-the-money options. The company has not repurchased appreciable amounts of stock in the last two years, not a negative considering the cash flow negative status of the company.
Expanding possibilities. Yes. Costco only has stores in 36 states at present, and its expansion focus in the last few years has been international, where less than 20% of the total revenues coming from outside the U.S.
Cash 1.5X debt. No. Debt for Costco is minimal ($800 million) compared to stockholders' equity ($4.8 billion). However, the company's cash position, given its conscious intense capital investment strategy, is deliberate.
Flow Ratio below 1.25. Yes. Costco's working capital management, as expressed by the Foolish Flow Ratio, is very good, averaging 0.81 over the last decade. We want companies that bring in cash fast and pay it out slow, and Costco fits the bill nicely.
Good margins. No. Costco's business model is based upon inventory turn, not margins. Operating margins, however, are consistently positive, showing pricing discipline by the company.
Looking through all of these items, I see that Costco meets five of the Rule Maker criteria, two are complete misses -- one with a good explanation and the other (high margins) is not applicable. Since we do not have full compliance with these criteria, I'm going to give Costco a "B" for business condition.
Fine, so we've briefly determined that Costco has a sustainable advantage and that it has some good economic characteristics. But should we buy it? How does it come up from a valuation standpoint? Costco would have been a stone cold lock "A" if we had been discussing it back in September, when it suddenly shed 30% of its value. Now, it's not quite so obvious a deal.
Costco's entire market capitalization is currently $18 billion. On an operating cash flow basis, this puts the company's multiple at about 17, and Costco does not have enough debt to make me think adjusting this upward is necessary. The question thus becomes, "How much of the company's capital expenditures are for new openings?" Well, la-dee-da, the management tells us in the 10-K. Capital expenditures for expansion are expected to be between $1.1 and $1.4 billion for 2002.
In other words, if Costco wanted to, it could ratchet back its capital expenditures to next to nothing. So, now the question is, "How many years forward will Costco plow all of its cash flow into growth?" Well, the company's not going to tell you, nor should it. This is where some good discounted cash flow work will come in handy. That's what I'm going to provide next week, as well as a good down-and-dirty look at how I personally would treat a company that does not meet our standards. I'll give you a hint: It's much easier to eliminate a company than it is to include it.
As always, any questions, comments, or really clever insults are most welcome on the Rule Maker Strategy Discussion Board. And if you want to start putting other companies through the paces, feel free to let us know on the Rule Maker Companies Board.
Bill Mann, TMFOtter on the Boards
Buy Polartec! Bill Mann owns none of the companies in this article. He does own a really cool chainsaw, though. The Fool is investors writing for investors.