We started a preliminary Rule Maker review of medical device maker Becton, Dickinson (NYSE: BDX) last week. Let's finish up the remainder of the review today.

Looking back on last week's column, I undersold the breadth of BD's product offerings by focusing on its market dominance in sharps and injection devices. BD actually has thousands of products, from blood and urine collection to centrifuges, reagents, laboratory products, exam gloves, and even ACE bandages.

It's easy to get locked in on a company's key market, but we should recognize that this is no one-trick pony. Still, BD's central business, its core, is needle-based medical technology. There, the company has the most significant advantage, so while I don't want to make short shrift of BD's other segments, you gotta dance with the one that brung ya.

As I noted in last week's column, BD produces more than 12 billion individual needle-bearing items per year. Such volume requires enormous operating overhead and would be nearly impossible for any company, save perhaps Johnson & Johnson (NYSE: JNJ), to replicate. Combine this with high-gross margins, and we've got a basic case for a Rule Maker.

5. Efficient working capital management, measured by a Foolish Flow Ratio below 1.25.
Here's a review of the equation for the Foolish Flow Ratio:

Flow Ratio = (current assets - cash*)
             (current liabilities - ST debt**)

* Cash = cash & equivalents, marketable securities, and short-term investments
** Short-term debt = notes payable and current portion of long-term debt

So for BD, we get the following, as of the most recent 10-K:

Current assets: $1.56 B (we're ignoring deferred taxes and prepaid expenses)
Cash: $.086B
Current liabilities: $1.26 B
ST debt: $.454B

Throw these numbers in the cash flow blender, and we get a Flow Ratio of 1.82. OUCH! That means BD, for all of its power in the industry, pays out money much faster than it receives it. One explanation is BD's purchasers are also dominated by a few large players, HMOs, hospital purchasing agents, and the like, which demand fairly stringent terms from suppliers. In this case, their day's sales outstanding nearly reach 80. A look at past financial statements tells me that this ratio has not deviated much over the last several years -- hovering at about 2. This isn't very good, though an improvement is the only discernible trend here.

6. Sales above $4 billion per year and growing revenues at 10% plus rates.
This line item represents a check on the size of the company. Rule Makers must be big companies in their own right, with market scope that makes them significant not just in their own industries but to the economy in general. This number, $4 billion, is also arbitrary. We're certainly not discarding companies that fall just beneath it. Such is the case with BD, which clocked in with revenues of $3.7 billion in fiscal 2001.

Over the last decade, the company's top line has grown approximately 5.5% per year, though that growth has been steady and constant. I expect the company's revenues will jump significantly with the higher-cost retractable needle technology currently under release.

7. Best-of-class management.
For the first three quarters of a century of its existence, BD was a family business. That changed in 1974, when the company named Jack Howe as CEO. Howe quickly set out to transform Becton from a sleepy family company into a global powerhouse. In his 16 years of running the company, BD expanded its product and geographic reach by leaps and bounds, with more than half of all revenues coming from overseas today. The top office has been a revolving door ever since, with the current occupant, Edward Ludwig, having ascended to the job in 2000.

The upcoming drive toward safety needles is a good example of high leadership standards. The company committed more than $500 million in capital developing retractable needle technology and the equipment to build it. It's a level of risk that many company managements would not have made, but once President Clinton signed the Needlestick Prevention Safety Act into law, BD was ready to produce the new technology in massive scale. The potential windfall for the company? Non-safety syringes cost hospitals a dime a piece; the new retractable ones cost a quarter.

There are signs of greatness in this management; however, I look at the slow rates of top-line growth despite a massive push into foreign markets and the poor Flow Ratio, and I'm not yet ready to make a determination. I will say the company's communications with shareholders are wonderfully clear and seem to be largely absent of hyperbole. Next week, I'll discuss the "one dollar premise," and use BD as an example.

8. Return on invested capital above 11%.
For 2001, BD's return on invested capital came in at 14%. That means for every dollar of invested capital, the company produced $0.14 in earnings for that year. That's a solid return, and it falls at about the general range for ROIC over the last several years, averaging at about 13%.

9. Cash no less than 1.5 times debt.
BD isn't even close on this one. It uses leverage and has maintained a consistent amount (around $700 million) for more than a decade, with its current long-term debt level at $782 million. Its cash on hand remained steady for many years, at well below $100 million, but in the last year, it has skyrocketed to more than $175 million.

For some reason, BD decided not to retain much cash in its coffers. But where does the money go? Dividend? Not likely, since its yield is a paltry 1.4%. The answer is partially in its high level of capital expenditures and R&D to build out the safe needle facilities, evident in the declining levels of R&D in the last three years. But BD maintains cash balances far below its debt levels. Were a cash crunch to hit the company, there could be trouble.

10. A reasonable purchase (or holding) price.
BD misses several Rule Maker criteria, though it does well in the first two -- the ones we consider absolutely required. It has a significant moat in the form of its assembly processes. No other company can come close to matching its level of unit output of 12 billion per year. This may seem impressive by itself, but recognize this: Those 10-cent items must also be positively free from defect. A faulty syringe is unacceptable, which makes this company's franchise all the more amazing.

So, when looking at a valuation for purchase, we need to remember that BD isn't likely to see significant erosion in its business. In fact, as the safe needle business becomes more widely distributed, I'd expect the company's top line and bottom line to grow substantially, perhaps by as much as 10% per year.

At present, BD has a market cap of $7.1 billion and generated free cash flow in 2001 in excess of $400 million, giving it a multiple to free cash of 17. Taken as a moment in time, that is not exactly cheap. Its ability to generate free cash over the last decade has shown consistent growth, up from $120 million in 1992. BD's position does give it a pretty good floor on cash flows absent something nasty and unanticipated, like a product liability suit.

Given the potential for growth and the level of safety that exists in Becton, Dickinson's existing businesses, I'd rate this stock a "pretty good," though not a great value.

Fool on!

Bill Mann, TMFOtter on the Fool Discussion Boards

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The Rule Maker Portfolio has had a cumulative investment of $42,500. As of Sept. 23, 2002, its current value of all cash and equities is $26,843.72. This equals an internal rate of return of -14.9% since the launch of the portfolio in February 1998.