I didn’t do a good job of explaining it properly; so, let’s look at the “true” profit margin of a company.

The Low Cost Business

We all know that it’s better to have a low-cost business than a high-cost business. Companies with relatively small capital expenditures and fat profit margins should be chosen over those with high capital expenditures and thin margins, assuming all other things are equal.

If you can find good companies that generate tons of cash on a relatively small amount of invested capital, and you can buy those companies at a discount to their intrinsic value, you’ll probably find that your long-term investment results are quite satisfactory.

Profit Margin on One Inventory Turn

So…we turn to two businesses, each of which has a thin profit margin, to see how inventory turns can give us some insight into the economics of the company. Let’s first look at the economics of the business from a single sale perspective to show that they’re the same:

(Note: The number of “inventory turns” refers to the number of times a company must replenish its inventory throughout the year. If Walgreens orders one case of Coca-Cola each month, and sells one case each month, it will have “turned” its Coca-Cola inventory twelve times that year.)

In this case, both businesses earned $2 on $100 of revenue. Their profit margins were 2% ($2 divided by $100). Fortunately, they lived in the land of Tina’s Family Therapy; so, no taxes or any other costs.

Both companies invested $98 in inventory (cost of goods sold), sold it for $100, and made a $2 profit. Simple enough.

Conventional wisdom would say that both businesses should be avoided. We’re supposed to look for businesses with wonderful economics, and a 2% profit margin is anything but “wonderful.” Then again, we’re all about being non-conventional around here.

Profit Margin on Multiple Inventory Turns

Same companies, but factoring one year of inventory turns into the mix:

Right off the bat, these companies may still look similar. Though Company A has greater sales and revenues than Company B, they both boast 2% profit margins and seemingly terrible economics.

Then again, these are businesses, not just numbers on a piece of paper. And the business of Company A is far superior to that of Company B from an owner’s perspective.

What Each Business Invested to Earn Their Income

Let’s first look at Company B. To generate $4 in income, it invested $196 in inventory (cost of goods sold), right? Wrong. Because it had two inventory turns, it invested $98 in inventory to generate $100 in sales, took the profit from that, reinvested the $98 in more inventory, and then turned another sale.

Essentially, Company B invested the same $98 twice to earn $4. Already see where this is going?

Company A invested $98 in inventory to earn $2, but was able to reinvest that $98 eleven more times to generate a total of $24.

Both companies invested $98 to earn $2, but Company A was able to reinvest it faster, thus generating six times more than Company B.

The “true” profit margin of Company A was not 2%, but 24%. The “true” profit margin of Company B was not 2%, but 4%. Here’s how it works:

True Profit Margins…as Bonds

Think of the true profit margin as a bond with a fixed interest rate. Would you rather have a bond paying 24% or a bond paying 4%? The answer is clear.

Company A and Company B both invested $98 into their business through the purchase of inventory. In essence, each purchased a $98 bond (the inventory), and that bond generates a certain amount of profit ($2). Except that Company A’s “bond” pays that $2 monthly while Company B’s “bond” pays $2 every six months.

Which company has better economics? They both have terrible profit margins from an accounting standpoint, but then again – accounting numbers are for the IRS. Business owners and investors follow the cash.

Which Company Will Grow Faster?

It’s pretty clear in the above example that Company A will have a better chance to grow faster than Company B. It generates more in sales, and it generates more cash. Let’s level the playing field. Instead of selling products for $100, Company B is selling higher priced goods. It buys products for $588 and sells them for $600. Both companies have the same revenues, cost of goods, net income, and profit margins:

So…which is the better investment?

Though it looks like we’ve leveled the playing field, we really haven’t. These are two very different businesses. To understand this, we have to work backwards.

How will Company A and Company B generate additional cash? With no other expenses, they each have three choices:

• raise the price of their products (e.g., from $100 to $105, from $600 to $630),
• lower their cost of inventory (e.g., find cheaper inventory at, say, $90 and $500), or
• sell more of their products.

If they can’t raise prices and they can’t find any cheaper suppliers, their only option is to sell more of their product. While that is great in theory, it ain’t so simple in the real world. Unless they have some magic formula for making cash appear out of thin air, how will they purchase additional inventory so that they can sell more of their finished product?

Assuming neither has cash in the bank or access to outside financing, they have one of two choices:

• require payment upfront, and then use the customer’s money to purchase inventory, or
• save up enough cash to purchase more inventory, using the funds of the business.

Some businesses can do the former; but, let’s assume that these two companies are retailers, and that their customers aren’t paying for clothes today, but willing to take delivery in sixty days. To get more inventory which will lead to more sales, the company’s must use the funds of the business.

But wait – neither company has cash in the bank! Okay – how long will it take before the companies can expand? That is…which company will grow faster?

In 4.1 years, Company A will have saved $98 from its $24 of profits – enough to purchase another unit of inventory. With two units of inventory both being sold concurrently, the company is generating twice as much cash.

It will take Company B 24.5 years to save up $588, if saving just $24 per year. As such, Company B will have to wait 24.5 years before it can double its cash flow.

Again – which company has the better economics: the one that can double every four years or the one that doubles every 25?

The Race is Over Before it Begins

If we fast forward and look at these two companies in 25 years, assuming that each tried to beef up their inventory at the end of the year (not 0.1 years into year 4), Company B has finally purchased another unit of inventory and will begin generating $48 a year in excess cash. Company A, on the other hand, has 465 units of inventory and is generating $11,160 in excess cash.

And while Company B has finally beefed up sales to $2,400 ($600 times 2 inventory turns times 2 units of inventory), Company A is generating $558,000 in sales – 233 times the amount of sales!

High Profit Margin/Low Turnover

Finally, consider this: A high profit margin business may have a very low “true” profit margin, and may be a candidate to avoid. When comparing a 2% profit margin business to a 10% profit margin business, many investors automatically assume that the 10% business is better.

That’s not necessarily true.

Everything else being equal, the 10% margin business with one inventory turn is no better or worse than the 2% margin business with five turns a year.

I apologize for any confusion I caused in this post.

That said, time and time again, the great value investors – Warren Buffett, Charlie Munger, Seth Klarman, and others – all teach investors one fundamental rule to intelligent investing: Stick with companies you understand really well…in industries you understand really well.

If you don’t know a company or industry really well, you have to choices: learn it or skip it. You should skip it while you’re learning. You should learn more so you have more choices and opportunities at your discretion.

Banks and Financial Services Companies

For years, I chose not to invest in banks and financial services companies because I didn’t understand them. My inability to understand them, it turns out, came from their “toxic assets.” See…understanding how banks and investment firms make money isn’t all that tough. You sell an investment or loan money…you get paid.

The problem was that I couldn’t expand my sphere of confidence and competence to include this sector because there were so many confusing assets and revenue streams that caused me to fail to understand their predictability.

I’m able to clarify my thinking in hindsight, of course. In August of 2007, just before the collapse, I had written this about US Bank and financial services companies:

Many financial services companies are difficult to value because they have so many diverse revenue streams that are tied to the performance of the stock market, the bond market, and/or the housing market. When a business has to rely on sales, it can control its growth (or losses); but, when a business has to rely on sales and uncontrollable forces, it forces me to lose some confidence in my valuation.

At the time, banks and financial services companies left me standing like a deer in the headlights; so, I didn’t invest. I couldn’t wrap my head around their businesses which, in hindsight, was because of their ridiculous investments (aka “toxic assets”). My ignorance caused me to miss a lot of profits in the mid-2000s; my ignorance caused me to miss even more losses in 2008.

Expanding Your Sphere

Of course, when blood runs in the streets, you again have a choice to make: stay on dry ground or get your hands dirty and look for opportunities. The fact that the streets are running red is not a reason to invest; rather, it’s an opportunity to expand your sphere of confidence and competence, and to determine whether or not you can find opportunities you understand really well…in industries you understand really well.

For example, the auto makers are getting crushed. I don’t bother looking because I know that the economics of their businesses are bad. I wouldn’t even look an auto maker as an ongoing entity until it hit critical failure and went into bankruptcy protection.

Over the past year or so, I spent a lot of time mulling it over – reading, studying, and understanding the financial crisis, banks, and the toxic assets. As the banks return to “normal” operations and lending practices and avoid stupid (er…toxic) investments, they become much more predictable and clear.

Buying Wells Fargo

So, on Wednesday, I added a 10% position to Wells Fargo at $23.41. (I guess I should have waited another day to buy it at $19 and change – who knew?) I have traditionally avoided banks; but, in studying them over the past few years, and in really coming to understand them (and their mistakes) in the past year, I feel much more comfortable owning Wells Fargo (though I wouldn’t be comfortable owning a financial services sector mutual fund or many other financial companies).

How did I end up purchasing Wells Fargo? I’ll post a more in-depth analysis in the coming days. For now, I’ll simply state this: Wells Fargo, like most banks, will have a tough few quarters and perhaps a tough few years. Still, when things return to “normal,” Wells Fargo will likely be a $100 to $150 billion company.

It’s far easier to tell what will happen than when it will happen.

Because of their strong position, I don’t expect Wells Fargo to be at the government’s bank window begging for a lifeline (though I wouldn’t be surprised to see them take TARP money – personal feelings about the bailout aside, a bank would probably be nuts not to borrow from the government on such favorable, easy terms).

How Do You Expand Your Sphere?

Read (and google what you don’t understand). Your “too hard” pile doesn’t have to be a black hole from which no company can escape. If you can learn enough about a business and industry to find the predictability and assess the value, you’ll begin to find opportunities where nobody else is looking.

Years later, you just might be amazed at your results.

To The Folks That Have E-mailed Me

I’ll respond this weekend – promise.

At the end of this post, you’ll find a “Buy Now” button to purchase a 20-page report comparing Free Cash Flow to Warren Buffett’s owner earnings. Though the two terms (free cash flow and owner earnings) are often used interchangeably, they are not always the same. Confusing the two can have a dramatic effect on your intrinsic value calculations.

This report:

• gives an overview of free cash flow versus owner earnings;
• thoroughly explains Buffett’s definition and formula for calculating owner earnings;
• walks the reader through a business – from start-up through Year 3 – to explain the financial statements;
• looks at General Motors’ free cash flow versus owner earnings and explains why the auto maker is suffering;
• and more.

Before you pay the hefty $19.95 price tag, please note that this report assumes that the reader has, at the very least, a basic understanding of financial statements. To give you a better idea of whether or not you want / need to purchase and download this report, check out the first three pages for free.

Does the company have a worthwhile profit margin?

To hammer the importance of this point home, you need not look further than traditional auto manufacturers.

Does the company have a worthwhile profit margin?

Auto manufacturers have historically low profit margins. MSN Money reports a 5-year industry average of just 3.4% for auto manufacturers versus 11.5% for the S&P 500. That is, for every dollar of sales at the auto manufacturer, just $0.03 ends up in net income. The rest is spent on costs of goods sold, operational expenses, etc.

Take, for example, General Motors. In its fiscal year ended December 31, 2007, General Motors reported $178.2 billion of automotive sales. To make the vehicles sold, GM reported “Automotive Cost of Sales” of $166.3 billion. Simple math would tell you that GM generated about $11.9 billion in revenue, after taking into account the cost of the materials to make the vehicles.

Here’s the problem: In the three years leading up to the end of last year, GM had to spend an average of $13.7 billion on “Selling, General and Administrative” expenses – the costs to keep the lights on, to keep the salespeople motivated, to advertise, etc. $11.9 billion in, $13.7 billion out. Starting to see the problem?

When Margins are Slim

If your company doesn’t have a “worthwhile” profit margin, it has a problem: When tough times surface (as they always do from time to time), weak margin companies will probably start burning cash rather than generating it. When things begin to turn around, your company’s ability to generate cash will be delayed relative to its high profit margin competitors.

As your company begins to use cash rather than generate it, your ownership is in jeopardy. I’m not just talking about negative free cash flow; your company will have to sell assets, fire people, take on debt, and/or sell more stock. The result: Less sales as capacity to fill orders is diminished, lower profit margins and excess cash as interest expenses increase, and dilution of your ownership resulting in less value going forward.

Check out GM’s balance sheet on Morningstar, and specifically look at the changes to shareholder equity. Here’s a company that has spent the last ten years trying to keeps its head above water, struggling to find a balance between too big to be profitable and too small to maintain unit volume. When margins are too thin, the slightest breeze can knock your business around.

The Owner’s Margin

Profit margins are important when looking at the industry and at historical figures for a company; the Owner’s Margin looks forward.

Calculated as owner earnings (or free cash flow) divided by total revenues, the Owner’s Margin can help you judge whether or not your business will be able to sustain prolonged periods of slowed sales or unusually high expenses.

In the case of General Motors, sales slipped and any excess cash they might have been able to eek out when times were good is now a pipe dream. Let’s turn our attention to Pfizer.

Generating about $10.6 billion in owner earnings last year on sales of $48.4 billion, Pfizer’s Owner’s Margin is 22%. That is, for every dollar of sales that Pfizer recorded, it generated about $0.22 in excess cash. Think of it this way: If sales at Pfizer sank 20%, or $9.7 billion, to $38.7 billion, Pfizer would still be able to crank out more than $900 million in owner earnings without firing a single person, selling a single asset, or assuming a dime of additional debt (if it’s business as usual).

A 20% hit to sales, and the company is still generating excess cash without making a single adjustment to its business? Now that’s a worthwhile margin.

Of course, some adjustments would likely be made. At that level, Pfizer would definitely have to kill its $8 billion annual dividend payments (unless management wanted to foolishly assume $8 billion a year in debt to keep the dividend). Furthermore, Pfizer would likely cut staff and take other measures to return to a more worthwhile margin. Still, the company has the operational capacity to sustain a very serious hit to sales without sustaining a commensurate hit to operations or its balance sheet.

When Times Get Tough

Going back to troubled companies. If you are attributing GM’s tough times to tighter consumer spending and higher gas prices, let’s move out of the beaten down auto sector and move to another business – Blockbuster.

For its fiscal year ended December 31, 2006, Blockbuster reported total revenues of $5.5 billion. It generated just $183 million of owner earnings – an Owner’s Margin of 3.3%. For the record, 2006 was a “business as usual” year for BBI.

Here’s where it gets hairy: To generate cash and actually have any sort of value for investors, Blockbuster needs to keep sales extremely high, to keep expenses extremely low, and to operate at perfect efficiency. Any slight change can have a dramatic effect on the business.

Well, it got hairy for Blockbuster. Revenues and most expenses in 2007 were largely unchanged. However, Blockbuster’s costs of sales increased by about 8%, from $2.5 billion to $2.7 billion. Owner’s Margin of 3.3%; cost of sales increase of 8%. Doesn’t look good for this fragile business.

Sure enough, Blockbuster’s operations swung from generating owner earnings of about $183 million to requiring an additional $114 million after all expenses were paid. Its Owner’s Margin dropped to a negative 2%. For every dollar of sales Blockbuster generated, it had to cough up $1.02 to keep the doors open.

In the highly competitive world of movie rentals (think Netflix, Wal-Mart, Apple TV, Comcast On Demand, etc.), a 3% Owner’s Margin is definitely not worthwhile. And Blockbuster shareholders have suffered because of it.

What Is “Worthwhile”?

The term “worthwhile” is relative, and depends on your estimation of how bad things can get at your company. If you are expecting a 50% hit to Pfizer’s total sales or a doubling of expenses at some point in the future, a 22% Owner’s Margin is definitely not worthwhile. If, however, in the ordinary course of business and economic cycles, you would not be surprised by 10% swings in sales, a 13% or 15% Owner’s Margin may very well be worthwhile.

As with everything in investing, look for a margin of safety. The higher the Owner’s Margin, the better.

Does the company have an above-average sales organization?

When your company is the company in its industry, your products virtually sell themselves. We’ve talked about Adobe here before (see the chart of Adobe market cap versus intrinsic value), but it applies once again to this discussion. Adobe’s products sell themselves. Why? The moat is absolutely massive. In the graphic design / web design world, Adobe is king, and adobe.com is the first place these people turn for new products, updates, and cutting edge tools.

It’s easy to spot the company in an industry – Adobe and Google come to mind. Then again, what if there is no true monopolistic leader? Or, what if you are the world’s leading provider of, say, operating systems for home and business computers, and then someone comes along and starts snatching your market share?

How did Apple leap from mediocre to marvelous? It’s not the mirrors; it’s the sales force.

The MP3 Revolution

It started with the iPod. In the 1990s, the popularity of MP3 players took off…and then seemed to die just as quickly. The industry remained dormant for some time as the broad public seemed to care very little about downloading music. The technology itself was mediocre. And let’s remember: This was a time when the internet was a free-for-all. Napster offered totally free music (and more), just waiting to be downloaded.

Enter the Apple Sales Force

The iPod was revolutionary in a sense, and not just because of its technology. Until Apple released it, MP3 players were poorly marketed. Along came Apple’s sales and marketing department with a crazy idea: Let’s put black silhouettes dancing in front of brightly colored backgrounds, with no detail but the iPod in white. You remember the commercials – a wild-haired silhouette having a blast, iPod earphone strings swaying along.

Was the commercial brilliant? Only for one reason – Apple incorporated widely known, well-loved (or extremely popular) songs into its marketing. Then, it rammed its commercials down your throat until you couldn’t help but see the silhouette dancing in your head every time you heard the song. After a while, the iPod became the industry standard MP3 player, and Apple became the company in portable music devices. Who knew people would rather spend hundreds on an iPod and pay for each song download from iTunes rather than spend pocket change for an “other” MP3 player and steal music for free (or buy it for peanuts)?

Apple shareholders: How about a big round of applause for Apple’s “above-average sales organization.”

Then, They Did It Again

If you have the best sales and marketing people in the world, you can sell anything. Having cornered the music market and having shut out the weak competition, Apple decided to go for the holy grail – Microsoft. Admittedly, I don’t know if Apple’s computers are better or not; then again, that’s not the point.

We could sell sand in the Sahara.

Apple came up with a brilliant strategy: Hit the techies first, and the people will follow. The “I’m a Mac; I’m a PC” revolution began, clearly geared towards “in the know” computer people. Admittedly, I didn’t even know that I had a PC – I had a computer, and it ran Windows XP. Having seen the commercials, I wanted to check out more. What the heck is an Apple / Mac? Why would I want one?

But Apple wasn’t trying to capture my attention. It wanted to let me know it was out there, and that I would eventually want a Mac. Initially, Apple wanted to capture developers – the people who would make my transition to a Mac easier because they would (i) be talking about it all the time, and (ii) be helping make the software and services I love Mac-compatible.

Me? Apple just wanted to let me know it was there, and that it would welcome me when I was ready to make the transition. While Apple waited for me, it gently, but constantly, reminded me of the headaches and problems I have with my “Microsoft” computer – too much garbage installed when I get the computer, not enough “fun” stuff (let’s face it – Microsoft Movie Maker stinks), and a constant threat of viruses with incessant updates leading to automatic restarts.

Though I’m still hesitant about switching to a Mac, many of my friends have done so. Though I have no need for an iPod, I’ll probably buy one for my wife and then use it all the time until I buy my own. And when I buy a new cell phone in the next month or two, you bet that I’ll look at that 3G iPhone. I don’t even know what 3G means; still, I know I don’t want to suffer through another Microsoft “smart” phone (nothing but nightmares) and my Blackberry is looking awfully boring now that I spend more and more time on the internet from my phone.

Judging The Sales Force

How does one judge the sales force? Better yet, what the heck is the sales force? The sales force is more than just the commission-based reps on the street. If Phil Fisher were around today, he’ probably change his point from “sales force” to “sales and marketing strategies that marry the various sales media, from the efforts of the sales reps to the quality of the print and broadcast advertising to the website.” (After all, Fisher would have known most of us check out websites long before we actually go to a store or call for more information and that the website is the “gentle half-step” between I’m interested and I’m ready to buy.)

You’ll know your company has an “above average sales force” if:

• It has great “traditional” marketing (see this post about marketing);
• Its website supports its sales efforts, rather than being little more than a “our company, about us, look what we can do” ego boost (it’s the 21st century; you can’t ignore the web anymore);
• It’s generating a lot of revenue per employee relative to its competition (AAPL: $1.1 million per employee; MSFT: $647,000 per employee);
• Its prospective customers know its name and products, and want them (even if they’re hesitant to switch today); and,
• It is (or is becoming) the company, if not in its entire industry, at least in a powerful niche of the industry (I still can’t buy a Mac from Dell, but I know where to turn if I want an Apple computer).

How Does This Apply To Our Pharmaceutical Discussion?

In a highly competitive environment, few products will sell to their maximum on their own. This is not necessarily the case with pharmaceuticals. Looking to do right by their patients, most doctors will not prescribe just any old drug the cute sales rep pushed that day. The drug has to be the best, with the least risk. Then, the doctor has to make a judgment call.

To help increase awareness of the name and effectiveness of the drug, we’ve seen (way too many) commercials spring up, telling us to ask our doctor about this drug and that, assuming we don’t mind the minor risks of chronic vomiting, bleeding from the eyes, and risk of hearing loss (you get the idea).

From a consumer standpoint, I don’t know what’s good or bad – particularly when a company asks me to remember some 30-letter, half-Latin half-English drug name (if you suffer from indigestion with uncontrollable sneezing, ask your doctor about Alexiopropalinal Digestneezinate). Then again, I do know what the purple pill is, and I might ask my doctor about it if I had acid reflux.

Odds are, most of this site’s readers (myself included) are not capable of judging the sales force of a pharmaceutical company unless they are (a) in pharmaceutical sales, (b) in the pharmacy, or (c) doctors. In that case, we have to get our noses out of the EDGAR database and get on the phone with friends and family that might fit into the categories above.

(Now if only my wife would believe that golfing with Joseph at Eli Lilly is “research”…)

The goal of R&D is to produce new products, services, or processes that will “still further increase total sales potentials” for the company. Not an easy question to answer, Fisher asks:

How effective are the company’s research and development efforts in relation to its size?

This is very much an industry-specific question with a near-unanswerable solution – one of the reasons there is so much art (versus pure science) in investing. Since both annual sales (revenue) and research and development expenses are published on financial statements, it’s fairly easy to come up with a mathematical answer by dividing R&D by total sales to see how much the company and its competitors spend each year.

Remember: The value of a company lies entirely in the future. The past does little more than offer insight into how the business has performed under various conditions. Still, we can look to the past to help us see into the future. So, let’s look at the above formula applied to a few companies. First, however, we qualify this discussion with Fisher:

Figures of this sort can prove a crude yardstick that may give a worthwhile hint that one company is doing an abnormal amount of research or another not nearly enough. But unless a great deal of further knowledge is obtained, such figures can be misleading.

Pfizer vs. Glaxo vs. Lilly

Ignoring dollar amounts for now, let’s compare the percentage of R&D spending at three of the industry’s major players. From 2000 to 2007, sales at Pfizer grew some 62% compared to 51% for Eli Lilly and 17% for Glaxo. Pfizer had the best gross margin – 83% – versus about 79% for the other two. In essence, Pfizer had a lower cost of goods sold which helped convert more sales into cash.

Of that after-sales cash, Pfizer spent about 19% on R&D versus 18% for Glaxo. Lilly was the clear winner on a percentage basis, spending about 24% of its gross profit margin on research and development.

As a percentage of sales, Lilly is spending the most on R&D – about 19% of gross sales and 24% of gross profits versus 15% of gross sales and about 18%-19% of gross profits for Pfizer and Glaxo.

R&D Growth

But who has been spending more and more in an effort to increase product lines? Over the past eight years, Pfizer’s R&D spending has increased about 72% – ten points more than sales. Lilly has increased R&D about 60%, or nine points more than its sales growth. Glaxo comes in with a 28% increase, a full eleven points above its sales increases.

On a percentage basis, Glaxo has been ramping up R&D the fastest (in relation to sales), Lilly spends the largest portion of its gross margin on R&D, and Pfizer has been ramping up R&D the fastest on an overall, absolute basis.

So, Let’s Try to Answer the Question

How effective are the company’s research and development efforts in relation to its size?

For the four full years from the beginning of 2000 through the end of 2003, Glaxo spent £10.9 billion (US $21.5 billion) in R&D, which translated into £6.7 billion (US $13.3 billion) in additional sales from 2004 through 2007.

During that time, Lilly spent $8.8 billion on R&D which resulted in $16.8 billion in additional sales from 2004 through 2007. Pfizer spent $22 billion in R&D and generated an additional $58 billion in sales.

You can’t look at these as a dollar-for-dollar translation; rather, focus on the results. They all have brilliant teams working long hours trying to develop the next blockbuster drug. Pfizer spent the most on an absolute dollar basis and enjoyed the greatest sales growth. Based on sales, Glaxo and Pfizer are roughly the same size. But Pfizer spends 17% (or $1.2 billion) more on R&D. Assuming researchers at both Glaxo and Pfizer are equally as smart, Pfizer is giving itself a better chance at developing a new wonderdrug and giving investors a better chance of benefiting from a new revenue stream.

But let’s not ignore Eli Lilly. With R&D spending of $3.2 billion a year – less than the other two, but still a full 20% of sales – Lilly is spending as much as it can to compete with its larger rivals.

Which Looks Best?

Out of the three choices, it’s a toss up between Pfizer and Lilly. In relation to its size, Lilly is spending the most on R&D. On the flip size, Pfizer is spending a comparable amount, but much more on an absolute dollar basis.

Then again, it’s research and development. With a much smaller budget, a tiny competitor can develop (or even stumble across) a wonderdrug and beat Glaxo, Pfizer, and Lilly to market. In that case, the money spent by the big boys on that particular drug is largely wasted. This is why the breadth and depth of the pipeline is so critical.

(For that and other reasons, a company like Amylin – with just $270 million in R&D and four drugs in the pipeline – are so speculative. If any or all of them fail or are beat to market, Amylin has to start from scratch.)

Think Outside The Pillbox

Looking at pharmaceuticals right now? Why not include TEVA in your research? While all the big boys are spending crazy money on R&D, hoping to develop the next wonderdrug and beat everyone else to market, TEVA sits back and scans the patent database to see when blockbuster patents are expiring. Then, it simply cranks out a generic and starts raking in the dough.

While Pfizer frets over its Lipitor patent, TEVA is licking its chops. Reverse engineering a drug to make a generic is nowhere near as expensive as the R&D required to create a new drug, as can be seen by TEVA’s relatively small R&D expenses. And since the Lipitor brand and results will be well known and documented, TEVA will have little to do but slap a label on a bottle and blow some money on marketing – and probably less than Pfizer will have to spend to try and keep its Lipitor market share.

How effective are the company’s research and development efforts in relation to its size?

When a major patent expires, you are rolling the dice, betting on which big pharma will have the next blockbuster. All the while, companies like TEVA are piggybacking big pharma’s R&D spending, without all the failures. To answer Fisher’s question above, I’d have to rank TEVA first, followed by a Pfizer and Lilly tie for second, with Glaxo coming in fourth.

Does the management have a determination to continue to develop products or processes that will still further increase total sales potentials when the growth potentials of currently attractive product lines have largely been exploited?

There are two schools of thought on this subject – the rational, business-like approach and the “other” approach.

The “Other” Approach

There is an old saying in business: Throw enough sh*t at the wall, and something’s gotta stick. In practice, many business owners (i) struggling to get by on their primary business, or (ii) poor at allocating excess capital, will expand into other areas. The thought process is simple (yet quite absurd): Business A can only go so far, so I’ll start Business B, C, and D and make a small living from each.

You see it all the time in publicly traded companies. Management has no idea what to do with their present business or excess cash, so they try to expand into other areas – most likely because they want to impress investors. (Think “Institutional Imperative”) Need an example? Check out Citigroup’s list of subsidiary companies as of their 2007 annual report. Let me break it down a bit.

Citigroup has 2,259 subsidiaries on that list. With 2007 revenues of $81.7 billion, that means that its average business generates about $36.1 million a year in revenue. Furthermore, it averaged about $15 billion in net income from 2003 through 2007, or about $7 million from each business.

Those Numbers are Skewed

You bet! We know that Citigroup has some very major, very core businesses – CitiFinancial and Smith Barney come to mind. It’s fair to assume that these core, massive businesses contribute the lion’s share of the revenue. So why does it own Southern Graphics Systems – a graphic design and packaging company – and how much do businesses like this contribute to the owners / stockholders?

No wonder Citigroup shareholders are up in arms, screaming that the company needs to dump some of its less-profitable businesses.

The Institutional Imperative

Citigroup is a classic case of the Institutional Imperative that Buffett speaks of. You have this wonderful investment business, and you go and do something stupid – like buy or start 2,200 more businesses.

Citigroup vs. The Rational, Business Approach

Warren Buffett is the embodiment of “rational, business approach” to growth. Berkshire has 50% more revenue, 2,200 less subsidiaries, and twice the market capitalization of Citigroup. Why? Buffett and Munger read Fisher.

Without any real products to sell, Berkshire’s “product” is capital allocation. To paraphrase (and slightly twist) Fisher, Buffett, Munger, and company have the determination to continue to allocate capital (via acquisitions) that will increase total sales potentials (read: cash flow for more capital allocation) when the growth potentials of current product lines (subsidiaries) have largely been exploited.

Berkshire owns Forest River – a trailer and RV company. Buffett and Munger know it doesn’t have the potential to be as big as Coca-Cola; still, it is an investment that will serve the company’s ultimate goal – to provide the two with more capital to allocate.

What Will Your Managers Do?

It’s not a question of whether or not the company has a lot of subsidiaries. It comes down to focus – does your management have it or not? To expand into new product lines or to make intelligent acquisitions, your management needs to be focused. The deals need to make sense.

When Coca-Cola owned shrimp farms in the late 1970s and early 1980s, it didn’t make sense. On the one hand, food and drink go together. Still, shrimp and Coca-Cola / wine / juice? It didn’t make sense. There could be very little resource sharing; Coca-Cola couldn’t minimize expenses because it had to run two very different businesses.

Look at Pfizer. 441 subsidiaries (yes, I know some of them are joint venture or other LLC/partnership-type arrangements). But they are pretty much all drug, research, or healthcare related (except Site Realty, which still has me scratching my head). Pfizer has been beaten down some 60% over the past eight years. Wall Street is worried that the November 2011 expiration of the Lipitor patent will effectively wipe out all $12 billion of Lipitor’s revenues, and destroy the company entirely. Granted, Lipitor generates about 25% of the company’s revenues; still, odds are, neither Lipitor nor Pfizer are not going to disappear entirely.

So, What is Pfizer To Do?

Right now, Pfizer is plowing $8 billion a year into research and development. The ultimate goal: “to develop products or processes that will still further increase total sales potentials when the growth potentials of currently attractive product lines [Lipitor] have largely been exploited.”

Pfizer is generating about $10 billion a year in owner earnings, with only about $2 billion in annual capital expenditures. With the Lipitor patent gone in three years, owner earnings are likely to decrease. What is Pfizer doing to prepare for that? Research and Development (here’s their “in the pipeline” report) and acquisitions of related businesses. Will it pay off? There is no way to know for certain; still, Pfizer management seems to be focused on the right process, and that’s all a shareholder can ask for.

If we start seeing products or acquisitions in unrelated businesses, or if it appears like Pfizer is giving up hope and content to do little more than battle the generics for Lipitor market share, get out of the way. Otherwise, Pfizer seems to fit Fisher’s Point 2 very nicely. It’s not enough to go on, but it’s a start.

Unfortunately, the future is more than a simple mathematical equation. Enter Phil Fisher.

Point 1. Does the company have products or services with sufficient market potential to make possible a sizable increase in sales for at least several years?

At first glance, this seems fairly self-explanatory. Will the company generate more and more revenue over the next few years? There are three simple answers: yes, no, and I’m not sure. We’ll skip the obvious “no” and “I’m not sure” answers as examples of businesses in which most investors should not be investing, and proceed with the “yes” businesses.

Not even the most outstanding growth companies need necessarily be expected to show sales for every single year larger than those of the year before….The vagaries of the business cycle will also have a major influence on year-to-year comparisons.

If you recall from this post about the business cycle, after a period of growth or sustained operations, companies will often have to take a step back to leap forward to further growth. Rarely do miracles happen in business; so, to develop a new product, introduce it to the market, and add the assets – both physical and human – required to properly sell the new product, a company will usually take on considerable expenses and burn through a ton of cash in the early years of research and sales. (The contraction phase of the cycle)

As early sales come in, the company will be scrambling to recoup its early costs. (The recovery phase) Sometimes it will happen very quickly (eg. Apple and the iPod); sometimes it will take many, many years (eg. Amylin), if at all.

Two Types of Consistent Growers

Those companies which decade by decade have consistently shown spectacular growth might be divided into two groups…”fortunate and able” and …”fortunate because they are able.” A high order of management ability is a must for both groups. No company grows for a long period of years just because it is lucky.

Fortunate And Able: Fisher talked about The Aluminum Company of America (Alcoa), but that was fifty some years ago. A more modern example (in my opinion) would be Google. In September of 1998, co-founders Larry Page and Sergey Brin brought Google online. These two men had a great vision – an internet search engine that ranked sites based on value rather than price. They were also very able on the technology side of Google. With an amazing product and a rapidly expanding potential market, the company then had to figure out how to make “sizable increase[s] in sales for at least several years.” (Early in its life, Google was generating no sales.)

In 2000, Google introduced AdWords, and its ability to generate revenue exploded. Like the founders of Alcoa, Google’s founders correctly foresaw a need for a democratic search engine based on relevancy and “votes” (or backlinks) rather than paid placement.

“But the internet grew like gangbusters. Doesn’t that make Google ‘fortunate because they were able’?” No. Google was a major beneficiary of the growth of the internet and search engines; still, assuming zero or slow growth in internet usage, Google would have likely dominated search engines by introducing a far superior product and grabbing market share in a slow-growing market dominate by pay-for-placement search results.

Thus, Google – at its roots – was “fortunate and able” in a rapidly expanding market.

Fortunate Because They Are Able: Today Google is now a “fortunate because they are able” company. Fisher discusses General American Transportation (GATX):

Yet when the altered outlook for the railroads began to make the prospects for the freight car builders increasingly less appealing, brilliant ingenuity and resourcefulness kept this company’s income on a steady uptrend. Not satisfied with this, the management started taking advantage of some of the skills and knowledge learned in its basic business to go into other unrelated lines affording still further growth possibilities.

Google realized that you can only place so many ads and make so much money from AdWords. Sure, the number of websites out there is growing like gangbusters, as is the number of internet users. Still, there is only so much money to be made on pay-per-click ads above and next to search results and on web pages. Recognizing this, Google decided to capitalize on its good name and existing (and expanding) customer base – to grow ever more “fortunate” because they were “able”.

Under the umbrella of “organizing the world’s information,” Google has rolled out dozens of new products and services – some paid, some free – to continue to capture market share and keep potential customers (AdWord’s clickers, small businesses, etc) coming back to Google for everything. If they can keep the world focused on the quality and speed of Google’s products, they know that Google will be the first place we turn when we need information, or anything to organize information.

“When someone needs driving directions, they come to Google and search for ‘maps’ or ‘mapquest’. Let’s keep them on Google by creating Google Maps.” According to Alexa, Google Maps gets some sixty times more traffic than MapQuest. And at the bottom of the Google Maps search? AdWords.

“Google Video isn’t taking off the way we want. Let’s buy YouTube.com and own the online video market. Once people equate the word ‘video’ with ‘you tube’, we’ll monetize it.” Allow me to introduce you to YouTube’s new advertising section.

Distinguishing Between The Two

This “Point 1″ of Fisher’s Fifteen Points to Look for in a Common Stock is critical. Does the company have products or services with sufficient market potential to make possible a sizable increase in sales for at least several years? Whether it is because the company is “fortunate and able” or “fortunate because they are able” doesn’t really matter. What matters is that they are “able”:

A high order of management ability is a must for both groups.

Though Fisher doesn’t really say so, I’ve found that smaller companies tend to fit into the “fortunate and able” category whereas larger businesses fit into the “fortunate because they are able” category. In order for a small company to become large, it must be fortunate and able. A large company can continue to grow large because it has the resources needed to become even more fortunate at the hands of very able management.

A small company doesn’t have the money or personnel needed to take Google’s current approach of “throw enough stuff at the wall, see what sticks, and then monetize it” so it must focus on its core business. (Think about it: Why didn’t YouTube buy Google instead?) A large company has the contacts and reputation to introduce new products and services with immediate credibility, thus offering a greater chance to become even more fortunate because it is able. Google introduced Gmail and it was an instant success, even in the face of strong, well-established competition from Hotmail, Yahoo! mail, AOL, and others. I suspect that my attempt to introduce JoeMail wouldn’t do nearly as well.

Which Is Better?

As Fisher’s Fifteen Points unfold over the next few weeks, you’ll see that “fortunate and able” is neither better nor worse than “fortunate because they were able.” Look for a good business that is run by a first-class management. When you find that, you’ll likely find that the distinction between “and” and “because” is blurred simply because your business flows back and forth between the two.

And that’s a hell of a company.

The Theory

The idea behind ignoring the assets is theoretically sound: The net assets produce the cash flows. Any reduction in net assets would reduce cash flows. Thus, the value of a business is comprised entirely of the future cash flows, plus excess capital that the business has.

The Question

So, what is considered excess capital? It is easy to say that additional cash above and beyond the company’s working capital needs is “excess” capital. What else might be considered excess capital?

In Buffett’s Own Words

We know that we should buy stocks as though we owned the entire business. In his January 18, 1963 letter to investors, Buffett said:

When control of a company is obtained, obviously what then becomes all-important is the value of assets, not the market quotation for a piece of paper (stock certificate).

So that there is no confusion as to his wording of “the value of assets,” Buffett then went on to show, in part, his calculation of value by presenting the balance sheet and his assessment of value for the company’s net worth (equity).

A Two Company Comparison

Let’s examine two simple businesses (the type we should be investing in). In this case, both companies generate $1 million a year in revenue, $250,000 a year in net income, and $300,000 a year in owner earnings:

To add a little more information, both are consulting firms in the same industry – each with 10 employees, both in the same location (just a city block apart), both having 100,000 shares outstanding, and neither having any long-term liabilities. In fact, except for one critical item (and I’ll get to that in a minute), these businesses would appear to be equal – and their valuations would also be equal.

The Balance Sheets

The one thing that separates these two companies resides on the balance sheet – a building. Company A operates out of a fully-owned, zero-mortgage building; Company B leases office space. Because the annual property tax plus depreciation for Company A is equal to the annual lease cost for Company B, the numbers work out identical. Other minor, but relevant, charges make net income and owner earnings the same.

Their respective balance sheets appear as follows:

As you look at these two companies, which would appear more valuable. Under the “ignore the balance sheet” calculation, the value of that building (and other hard assets that don’t appear in the “excess capital” calculation) would be zero.

The Valuation

Using the F Wall Street valuation, Company A is worth $5.65 million. Using the “ignore the assets” valuation (assuming 10 years of cash flow plus 10x the sale price), the valuation is similar – $5.63 million. (For both, I assumed 10% growth for three years, followed by 8% for three years, followed by 6% for four. Then, 5% going forward for F Wall Street valuation.)

All things being equal, the valuations come out to be about the same. So, is there value in the assets?

The Direct Hit

Again, it is our job to think like business owners. What is the safeguard provided by Company B? That is, if the consulting business goes down the tubes, what happens to your investment? Company B would liquidate and pay shareholders a total of roughly $63. Company A would pay us $513.

Of course, we didn’t pay full price for those assets. We got the building at a discount (part of our margin of safety) and so we expect to recoup more than Company B shareholders.

The Asset Conversion

What if the companies don’t go out of business? Instead, they continue on at the rates assumed (above). However, Company A hires a consultant that tells management to sell the building and swap down to lease office space like its competitor does.

Company A does just that. Now, the company has an additional $450,000 in cash. According to the “ignore the assets” school, the business just became immediately worth $450,000 more because it has “excess” capital, and now they would value the company at $6.08 million ($5.63 million plus $450,000 in excess capital).

Here’s the problem: Company A now looks exactly like Company B, except that Company A converted its building into cash (excess capital). The day before the building was sold, Company A (according to the “ignore the assets” school) was worth $5.63 million (the same as Company B). The day after the building was sold, Company A was worth $450,000 more.

Did the company really increase $450,000 in value? Or, was that value there, and simply ignored? Is Company A worth $5.63 million when it owns a building, but worth $6.08 million when it converts that building into cash?

The Dual Value of a Company

Each company has two values – the assets and the future cash. Some assets are critical earning assets – assets that the company needs to generate owner earnings. Some are non-earning assets that simply add to the value of the company.

If you ignore the balance sheet and assets, you can get caught with your pants down when your business converts non-earning assets into cash, and you pay considerably more for the same business.

We’ll end with another early Buffett quote, this time regarding the Sanborn Map purchase:

This means, in effect, that the buyer of Sanborn stock in 1938 was placing a positive valuation of $90 per share on the map business ($110 less the $20 value of the investments unrelated to the map business) in a year of depressed business and stock market conditions. In the tremendously more vigorous climate of 1958 the same map business was evaluated at a minus $20 with the buyer of the stock unwilling to pay more than [seventy cents] on the dollar for the investment portfolio with the map business thrown in for nothing.

The take-home lesson: Buffett put one value on the assets and another on the business (or future owner earnings). He mashed them together, and bought a business at a substantial discount. Lest you think that the “investment portfolio” was simply excess capital, had the company been selling for 70 cents on the dollar with tons of money in real estate (that wouldn’t show up as excess capital), it would have still been a great play.

Think Burlington Northern.

Do GAAP earnings drive free cash flow? Or, does free cash flow drive earnings?

The Accounting

Businesses can have very complex accounting practices. Still, whether you are looking at business finances or personal finances, the basics are the same. No matter what you report to the IRS-no matter how good (or bad) you look on paper-you or your business will financially survive, thrive, or die based on how much cash you can generate.

Let’s break down a simple example of how dollars flow through a fake business:

1. Company spends $20,000 marketing its consulting service.
2. $200,000 flows into the bank because customers paid for consulting services.
3. $100,000 (50% of revenue) is spent by the company on utilities, salaries, etc.
4. $80,000 is left in the bank at the end of the year.

Uncle Sam^† Wants His Cut

Tax time. Our business has to file its return. What wasn’t shown in the above is a “depreciation” expense-a write-off that the company is allowed to take based on a prior purchase of equipment. For the sake of simplicity, let’s assume the company won’t have to re-buy or replace that equipment for the next two or three years.

On its tax return, the company shows:

1. $200,000 of revenue,
2. $120,000 of expenses that required cash,
3. $20,000 of depreciation-even though it didn’t require cash and doesn’t appear in the above report.

As far as Uncle Sam is concerned, our business had a taxable income of $60,000. In the US, this company would pay $10,000 in taxes (2006 rates) leaving it a net income of $50,000.

Net Income Vs. Free Cash Flow

To calculate free cash flow, we have to follow the cash. In practice, we simply add that depreciation back in to the net income (along with some adjustments). In reality, the actual free cash flow calculation would start with revenue and subtract any cash expenditures:

1. $200,000 of revenue
2. - $120,000 of cash expenditures
3. - $10,000 of taxes paid in cash

For this company, free cash flow would be $70,000 even though net income reported to shareholders and the IRS was $50,000.

Question: What Drives What?

Does free cash flow drive earnings? Or vice versa? Here’s the reality: No matter what the earnings were for the year-no matter how creative or conservative the company was with its accounting-this business has $70,000 in cash that it can use to grow.

What will it do? Well, we saw that it previously spent $20,000 on marketing to generate $200,000 of revenue. Assuming it wanted to (and could) repeat that performance, the business would invest that full $70,000 in marketing to generate $700,000 in revenue-assuming it was that easy!

Answer: Free Cash Flow Drives Earnings

A year passes, and our business used that $70,000 for marketing. Here’s how the year played out:

1. Company spends $70,000 marketing its consulting service.
2. $700,000 flows into the bank because customers paid for consulting services.
3. $350,000 (50% of revenue) is spent by the company on utilities, salaries, etc.
4. $280,000 is left in the bank at the end of the year.

Again, we pay the piper. After deducting another $20,000 in depreciation, Uncle Sam collects $84,650 in taxes. Net income comes in at $175,350; free cash flow is $195,350.

The Key Is Cash Flow

Why did earnings increase? Simple: The company generated enough cash to fuel earnings. Had our business only generated $20,000 in excess cash, it would have only had $20,000 to spend on marketing and we could have only expected around $200,000 of revenue (or a $200,000 increase depending on whether or not past customers were buying again).

Creative Accounting

Yes-businesses can mess with their accounting to look better or worse than they are. Still, no matter what our business did to its tax return figures and net income, it had exactly $70,000 to fuel growth. Could the executives have stolen that cash and screwed with shareholders? Perhaps. Still, if that is the number one reason you are scared to buy stocks, you certainly shouldn’t be in the markets in the first place.

^†Non-U.S. readers: Uncle Sam is a reference to the US Government and/or the US Internal Revenue Service (IRS).