Back to Basics, Part 3 (Rule Maker) July 8, 1999

<THE RULE MAKER PORTFOLIO>

Back to Basics, Part 3
Income Statement Analysis

By Matt Richey (TMF Verve)

ALEXANDRIA, VA (July 8, 1999) -- This week, we've been walking through the core elements of the Rule Maker strategy, in particular focusing on the portfolio's ten most essential investment criteria:

1. Dominant brand
2. Repeat-purchase business
3. Convenience
4. Expanding possibilities
5. Your familiarity and interest
6. Sales growth of at least 10%
7. Gross margins of at least 50%
8. Net-profit margins of 7% or greater
9. Cash no less than 1.5x long-term debt
10. Efficient use of cash (Flow Ratio below 1.25)

Tonight, let's turn to the financial side of our Rule Maker Essentials, and look at #6 - #8 -- sales growth, gross margins, and net margins -- which are what we consider to be the three most important metrics deserving your attention on the income statement. As with last night's report, the following steps benefited significantly from both the thinking and writing of Tom Gardner.

Alright, let's get started on the numbers... something to hold onto... something to tap into your calculator or spreadsheet! Or perhaps numbers make you shudder�don't worry, though, these are easy.

Sales growth is the most fundamental indication of an expanding business. While net profit growth is important too, it can be the result of cost-cutting measures rather than pure business growth. Cost-cutting is all fine and well, but we want to isolate a company's ability to sell more and more of its stuff year after year. And that's exactly what sales growth tells us. We're looking for companies that are growing sales (a.k.a. revenue) by at least 10% per annum. This metric is easy to calculate. Using a company's income statement, simply divide the current year's sales by the previous year's sales and subtract one.

Here's an example:

Schering-Plough (NYSE: SGP) Fiscal Year 1998

1998 Sales   1997 Sales   Growth
$8.08 bil    $6.78 bil    19.2%

Again, we like to see sales growth (current sales divided by year-ago sales minus one) of at least 10%.

Strong sales growth is dandy, but only if each dollar of sales is profitable. We will not be making a long-term investment in the Rule Maker portfolio in any companies that aren't profitable. Riskier investments in smaller, unprofitable companies can make sense. But, since we'll be focusing on mature, consumer-brand behemoths, we want to see substantial profits already in place. So continuing with the income statement, let's look at gross margins.

Gross margins are defined as the gross profits (sales minus cost of goods sold) for a period divided by the revenues for the same period. (If you just got dizzy, we apologize. This is easy. Re-read that.) Here we would like to see gross margins ringing in above the very lofty perch of 50%. In other words, we'd like the company's cost of making the product or providing the service to be no more than half of what that product or service can be sold for.

Here's an example:

Schering-Plough Fiscal Year 1998

Sales       Cost of       Gross        Gross
            Goods Sold    Profits      Margin
$8.08 bil   $1.60 bil     $6.48 bil    80.2%

It's nice to know that a company can sell its products for double the cost of producing them, but that'd be of little positive consequence if the promotion and overhead expenses associated with that product ended up wiping out the profits. We want the company to still earn good money, even if they pay out $1 million for that advertisement on the Super Bowl. And we don't want the government's 35% tax bite to whittle the bottom line into nothingness.

Therefore, our next objective is that net profit margins be at least 7%. The calculation is net income (after all expenses, which include taxes, the marketing and administrative expenses, etc.) divided by sales. So, simply divide the bottom-line earnings by the top-line sales to figure the net profit margin.

Here's an example:

Schering-Plough Fiscal Year 1998

Sales       Net Income     Net Margins
$8.08 bil   $1.76 bil          21.8%

That's it for the income statement. But no financial analysis is complete without a look at the balance sheet, as well. We'll do that tomorrow.

Until then, if you have any questions about this financial stuff, drop by the Rule Maker Beginners board (linked below) and get your question answered. Lots of friendly Fools hang out on that board and welcome even the "dumbest" of questions.

Finally, are you tracking your Rule Makers and the rest of your portfolio against the S&P 500? It's a snap with the Fool's "My Portfolio" feature. Check out this post to hear how one Fool reacted after using it for the first time. Then go to My Portfolio (also accessible through the Fool's top menu bar) to get started with just a couple of mouse clicks. It's free. All you have to do is become a registered Fool (also free), if you haven't already.

Stock Change    Bid
AXP   -2        133.75
CHV   -1 9/16    98.13
CSCO  +  3/16    66.44
EK    +  1/16    70.69
GM    -2 5/16    67.75
GPS   +2         51.63
INTC  +1 3/8     65.75
KO    -  1/8     63.13
MSFT  +  1/4     92.56
PFE   -  9/16    37.19
SGP   -  3/4     51.75
TROW  -1 11/16   36.00
XON   -  13/16   79.63
YHOO  -2 5/8    164.44

                  Day     Month  Year    History
        R-MAKER  -0.21%   1.95%  15.96%  46.73%
        S&P:     -0.10%   1.58%  14.02%  41.00%
        NASDAQ:  +1.05%   3.21%  26.41%  67.70%

Rule Maker Stocks

    Rec'd    #  Security     In At       Now    Change
    2/3/98   48 Microsoft     39.13     92.56   136.52%
   6/23/98   68 Cisco Syst    29.21     66.44   127.49%
    5/1/98 82.5 Gap Inc.      22.91     51.63   125.31%
   2/13/98   44 Intel         42.34     65.75    55.30%
    2/3/98   66 Pfizer        27.43     37.19    35.56%
   2/17/99   16 Yahoo Inc.   126.31    164.44    30.19%
   5/26/98   18 AmExpress    104.07    133.75    28.52%
   8/21/98   44 Schering-P    47.99     51.75     7.83%
    2/6/98   56 T. Rowe Pr    33.67     36.00     6.91%
   2/27/98   27 Coca-Cola     69.11     63.13    -8.66%

Foolish Four Stocks

    Rec'd    #  Security     In At     Value    Change
   3/12/98   20 Exxon         64.34     79.63    23.77%
   3/12/98   15 Chevron       83.34     98.13    17.74%
   3/12/98   20 Eastman Ko    63.15     70.69    11.94%
   3/12/98   17 General Mo    72.41     67.75    -6.43%

Rule Maker Stocks

    Rec'd    #  Security     In At     Value    Change
    2/3/98   48 Microsoft   1878.45   4443.00  $2564.55
   6/23/98   68 Cisco Syst  1985.95   4517.75  $2531.80
    5/1/98 82.5 Gap Inc.    1890.33   4259.06  $2368.73
   2/13/98   44 Intel       1862.83   2893.00  $1030.17
    2/3/98   66 Pfizer      1810.58   2454.38   $643.80
   2/17/99   16 Yahoo Inc.  2020.95   2631.00   $610.05
   5/26/98   18 AmExpress   1873.20   2407.50   $534.30
   8/21/98   44 Schering-P   2111.7   2277.00   $165.30
    2/6/98   56 T. Rowe Pr  1885.70   2016.00   $130.30
   2/27/98   27 Coca-Cola   1865.89   1704.38  -$161.52

Foolish Four Stocks

    Rec'd    #  Security     In At     Value    Change
   3/12/98   20 Exxon       1286.70   1592.50   $305.80
   3/12/98   15 Chevron     1250.14   1471.88   $221.74
   3/12/98   20 Eastman Ko  1262.95   1413.75   $150.80
   3/12/98   17 General Mo  1230.89   1151.75   -$79.14

                              CASH     $70.09
                             TOTAL  $35303.03