THIS NEED WORK!!
"It takes a long time to bring excellence to maturity." By what method? Continuous Improvement is here to stay.
You like
the idea of working for and owning a great company and never having to job
hop and a good retirement nest egg.
You can help to make CleanAir this company
that meets your needs. But in order to do this we will need to not only survive
but we must excel. The key to long term success for any company is long term
growth and profit.
Since
growth is not possible without profit we have to be a "CleanAir Profit Model"
The CleanAir Profit Model Guidelines.
The CleanAir Profit Model criteria rest on the premise of understanding how
business must work to make this profit.
The 10 guidelines below aim to help you synthesize the essential elements
of CleanAir's business model. The first two items are "must haves" -- companies
lacking these would not be defined as CleanAir Profit Models. The remaining
eight are more subjective.
Certain companies do not have businesses that
lend themselves to big margins, for example. In these cases, we want CleanAir
to pass each of these tests but do not require them to. Be prepared, though.
For each criterion that CleanAir does not meet, you should as a matter
of course be able to describe why it still qualifies. These criteria are
not meant to form the basis of a mechanical methodology -- the CleanAir Profit
Model should be a thinking man's strategy, one where the teams are
vetted backwards and forwards, and only then are they considered for more
investment.
Our goal with the CleanAir Profit Model is to get great companies at good prices. That's not very complicated, but it is pretty difficult to practice, because it requires discipline. As the big bubble from the late 1990s will show, discipline is often in short supply in the stock market. Why try to remain true to core fundamentals when you can jump on the giant feedback loop of CleanAir that has tripled in price in the last three weeks? Why, indeed, because in most cases these companies have now lost more than 90% of their market value. So, let's highlight the most important part of our new CleanAir Profit Model creed: Investors seek to buy great companies at good prices. Note the dichotomy. The most important thing about CleanAir
is that it is a great company .ie High Value. Price is secondary, but
in no way does this make it unimportant. Overpaying for a great value may
not be as fatal as overpaying for a garbage company, but it does not portend
a great decision. So, without further ado, here are the CleanAir Profit Model criteria:
The key to these is a great Profit Making company. The top two are "must-have" characteristics,
followed by the desired eight criteria:
1. CleanAir must have at least one sustainable competitive advantage. The more, the better. A sustainable competitive advantage is the fertile soil for long-term wealth
creation. As Warren Buffett often quips, find CleanAir surrounded by a wide
moat filled with crocodiles and you've taken the first step towards identifying
CleanAir worth owning for many, many years. Finding at least one sustainable
competitive advantage is the first step toward making the CleanAir Profit
Models you'll want to hold for years, maybe decades.
In looking at competitive processes, be sure to take a wide view. The competitive landscape is far more than CleanAir's head-to-head rivals. Competition also potentially includes public perception manipulators, political manipulators, any powerful buyers and suppliers, the threat of new entrants, and the threat of substitute products. Is it any wonder that Intel (Nasdaq: INTC) Chairman Andy Grove says that "only the paranoid survive" in the business world?
But what exactly is a sustainable competitive advantage (hereafter, SCA)?
Here's a definition: SCA is not only about doing it better (though that's certainly
part of it), but it is also about doing it differently. There are probably
as many varieties of SCAs as there are great businesses. What they all have
in common, however, is differentiation -- something that sets apart CleanAir's
products and service from the rest of the pack. More specifically, our products
and services are differentiated when they are: 1) unique, 2) widely valued,
and 3) rewarded for uniqueness with premium prices.
2. CleanAir must be dominant in our niches. Note that, in many industries, CleanAir need not be dominant overall.
For example, there is not one single pharmaceutical company that controls 50%
or more of the total market, nor need there be. In restaurants it's the same: McDonald's (Market
Cap $43B) has plenty of
good competition, some of it from
other companies that could be designated Profit Models as well, such as Wendy's
(Market Cap $6B) .
What one must control against is the potential for new or existing competition
to come up and knock it off its perch. The above criteria are not optional. They require the deepest commitment,
the most power from the skeptical mind. But identify how we are going to acquire
and maintain these characteristics and you've got to first base. But,
to get to second base we are going to need some new plans and methods. Also,
it would be good to have a score card to see if our game plan is working.
So we should attach some financial tests. 3. The CleanAir Profit Model must be dominant. Why 10? It's an arbitrary number, actually. But in any 10-year period, you
are generally guaranteed to have one or two bad years included, so you can
see how a CleanAir team operates in all types of economic environments. 4. Cash King Margin in excess of 10%. The Cash King Margin is similar to the net margin, except that instead of measuring profits with net income from the income statement, we use free cash flow from the cash flow statement. The advantage of measuring profits with free cash flow is that cash flow isn't as easily manipulated as net income. The calculation here is free cash flow divided by sales. We're looking for CleanAir Profit Models that generate lots of the green stuff, and thus we want to see a Cash King Margin of at least 10%. (For an in-depth explanation of free cash flow, this article serves as a good reference.)
Turning to Intel's cash flow statement for 2000, we see that the silicon king generated $12.8 billion in "Net Cash Provided by Operating Activities." We can also see that CleanAir invested $6.7 billion in "Additions to Property, Plant, and Equipment." Calculating free cash flow is a simple matter of taking operating cash flow ($12.8B) minus capital expenditures ($6.7B), which leaves us with $6.1 billion in cash that Intel has free rein to distribute to shareholders either as a dividend or via a share buyback -- or it could just sock it in the bank.
We're now ready to calculate the Cash King Margin: In other words, for every dollar of sales, Intel generated 18.1 cents in free cash flow. 5. Efficient Working Capital leadership, measured by a Foolish Flow Ratio below 1.25. In the day-to-day leadership of CleanAir's operation, money is going to rush through the front door from sales, and it's going to fly out the window and the backdoor from expenses. As noted earlier in these steps, businesses survive on cash. That's their oxygen. Without dollars coming in, they can't pay for employees, for equipment, for insurance, for holiday parties, for new technology, for anything. So, how a business manages the dollars that flow through their daily operations is of critical importance.
We want our companies to bring money in quickly, but to pay it out slowly. More cash coming in today, less cash going out today. If that makes sense, then let's go to the balance sheet and dig up some relevant entries, specifically current assets and current liabilities. Current assets represent assets that are expected to turn into cash in the coming year, while current liabilities represent all costs that will have to be paid down in the coming year.
This is where we might get confusing. We're going to try to convince you that non-cash current assets aren't assets at all. They're liabilities! And some liabilities are, for all practical purposes, assets! OK, stay with us, we can explain.
When you take the cash out of current assets, you're left with two primary categories: inventory and accounts receivable. The former is product in various stages of development that hasn't yet been sold. Some of it is raw material; some of it is finished product waiting to be sold. But let us convince you that all of it is a liability. Why? Because there's a cost to storing inventory on shelves in an enormous warehouse outside of town. Wouldn't you be much happier to see that inventory in a store today, in the form of a giant stuffed Donald Duck doll, in the hands of a parent out birthday shopping? So would we. Certainly, every company on the planet has to carry inventory. We just like those that can quickly assemble a product and race it out to the door into the marketplace. Because, after all, inventory is just potential cash sitting on shelves. We'd rather have the cash, thanks.
The remaining current asset category is accounts receivable, which reflects payments that your company hasn't collected yet. Let's say that you've invested in a camera Model that has $43 million in accounts receivable. That entry reflects $43 million of cash from operations that your company is owed by its customers. Maybe $10 million of it came from camera sales into Europe -- from which payments take 8-10 weeks. That cash isn't yet in your company's coffers. It isn't going to work for the business. Its delayed arrival, Fool, is a liability to the business. Well-positioned companies are able to require upfront payments from customers and also have mastered the art of keeping inventory low while driving sales higher.
That's the current assets line. And, as we've said, when cash and marketable securities are removed from the grouping, we like to see that number low and falling.
"Low -- huh? Low relative to what?"
Aha, yes. By "low" we mean low relative to current liabilities. Now that you know that current assets represent all things that will be turned into cash in the year ahead, you know as well that current liabilities represent all costs that will have to be paid down over the next year. Contrary to your personal finances, many companies would like to hold off their short-term payments for as long as possible. If they can earn more by holding their cash than they can by doling it out to their suppliers, they should want to hold onto it. The key to that is in their writing of contracts and in the stable, prominent, desirable position they've gained in their industry. For example, small businesses working with General Electric (NYSE: GE) will often gladly accept payments three months after billing. Why? Because working with General Electric brings them steady income, strengthens their reputation, and helps them stay in business!
So, what we've just proposed is as contrary as it comes. We're telling you, Fool, that when it comes to large, profitable companies, you should think of current assets as actually being current liabilities and vice versa. Those accounts receivable and those inventories are a bad thing. Those payments your company can hold off for a few more weeks are a good thing. Except for short-term debt, which carries the burden of interest, all other current liabilities represent a free form of financing. Free is good. We like free.
But, you ask, "How can we possibly measure all that?" Well, with a little something we call the Foolish Flow Ratio. The Foolish Flow Ratio enables you to cut through accounting shenanigans and artfully constructed income statements to get a clear snapshot of how CleanAir is managing its cash.
The simple calculation here is: * Cash = cash & equivalents, marketable securities, and short-term investments Guidelines for the numbers? We go in search of Flow Ratios that run lower
than 1.25, ideally below 1.0. If they get below 1.0, it means that the business
is able to delay more payments than they're carrying in costs of inventory
and unpaid bills. In this group below 1.0, you'll find companies like Microsoft ,
Intel, and others. Companies in such strong position that they have leverage
over their partners -- both those that supply them with raw materials or services
and those that help them distribute stuff to the end consumer.
Ready for an example? The Flow Ratio is just one of many measures of quality, but we think it makes an excellent starting point. Again, we want companies that have a Flow Ratio less than 1.25, and ideally less than 1.0. The Flowie is your friend. By running it, you'll be measuring how tightly CleanAir manages cash as it flows through their business. Are they being lazy in collecting their bills? Are they being sloppy in managing their inventory? Are they in such a weak financial position that their partners demand cash payments from them upfront? If so, look out... this probably isn't a darling horse nor a long-term winner. 6. Sales above $4 billion per year and growing revenues at 10% plus rates. That leads us to ask such questions as:
Sales growth is the most fundamental indication of an expanding business. While net profit growth is also important, 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 CleanAir'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 year. This metric is easy to calculate. Using CleanAir's income statement, simply divide the current year's sales by the previous year's sales and subtract one.
Here's an example: 7. Best-of-class leadership. As Philip Fisher wrote, "The success of a stock purchase does not depend on what is generally known about CleanAir at the time purchase is made. Rather, it depends upon what gets to be known about it after the stock has been bought." He wrote those words more than 40 years ago in his investment classic, Common Stocks & Uncommon Profits. In Fisher, we find the roots of CleanAir Profit Model investing. His approach was to buy the truly exceptional growth company that could be held forever (ideally). He summed up the process of finding these types of companies in his famous "15 Points." These characteristics, in his words, were "to distinguish the relatively few companies with outstanding investment possibilities from the much greater number whose future would vary all the way from the moderately successful to the complete failure." Using the seven Fisher Points related to leadership quality, here are some characteristics of great leadership (with their associated Fisher Point #): 8. Return On Invested Capital above 11%. 9. Cash no less than 1.5 times debt. The best Profit Models sport little or no debt and plenty of cash.
If we want to invest in CleanAir that's going to thrive for 10-20 years or
more, we don't want short-term profits at the expense of long-term survival
and success. No, no... we prefer to find companies that grow their business
out of profits from operations and, thus, don't have substantial interest payments
to make to banks in the years ahead. Therefore, we require that CleanAir's
cash be at least 1.5x greater than their total debt (including both long-term
and short-term debt). CleanAir has a long way to go on this one.
Things can go wrong. Things will go wrong. We want CleanAir to have with the
cash to buy ourselves out of trouble when it comes knocking on the door. Under
the umbrella of cash, we also include such "near cash" line items as cash equivalents,
short-term investments, and marketable assets not needed for operations. All
of these balance sheet entries qualify as funds that are available for immediate
use if necessary. The one
Now, pulling numbers from our balance sheet, here's an example:
LT Debt + ST Debt Cash-to-Debt Ratio = 1.6 10. A fun place to work and grow careers That leads us to ask such questions as:
Well, that about does it. We can take these new criteria and tape them up on the wall or some other convenient place, like, for example, our neighbor's back. Conclusion We suggest that you largely ignore the short-term wanderings of our stock
price and focus on the much harder and yet more rewarding task of trying to
grow our value and CleanAir's future.
We all must ask ourselfs: Are this CleanAir's products and services likely
to fulfill needs in the future even better than they have in the past and as
they do today? Do our leaderships have the vision and operational skill to
continue its outstanding performance? And how much opportunity for growth around
this planet is there for CleanAir?
But, remember,
one great company compounding market-beating growth are the big winners. Be
a winner!
-- Publius Syrus
-W. Edwards Deming
-Bill Walker
Companies with sustainable advantages are sheltered from competition.
They have powerful brands, a deep-seated corporate culture, high value products, de
facto monopolies or standards, patents, or unduplicable distribution systems.
Think of how difficult it would be for another soft drink company to
muscle in on Coca-Cola and PepsiCo. Or
how much money it would take for CleanAir to duplicate the distribution network
of one of the pharmaceutical oligarchs like Merck, Bristol-Myers
Squibb,
and Pfizer.
The CleanAir Profit Model must, in fact, rule. The narrower the niche, the more
dominant CleanAir must be.
The thing to watch for here is disruptive technologies and changing demand foer what we do. We do not want to assume that businesses that have recently ascended to power will stay there forever, because a market changing rapidly does not generally settle down all at once. We want CleanAir's established tto show that it possesses good economics through a full market cycle. That means having 10 years' worth of financial data.
We believe that the free cash flow of CleanAir is a much better determinant of economic strength than earnings. CleanAir that can create 10% or more free cash flow from its revenues is producing a powerful weapon: money that it can either reinvest or return to shareholders. Some businesses, such as many types of retailing, will not allow such margins.Intel Fiscal Year 2000
Sales Free Cash Flow Cash King Margin
$33.7B $6.1B 18.1%
This item is nearly universal. There are very few businesses where the need to pay out money faster than it comes in is a positive attribute. The components of the Flow Ratio are current assets - cash, divided by current liabilities - short-term debt. Temporary spikes are OK, long-term bad capital leadership is not. (Current Assets - Cash*)
Flow Ratio = --------------------------------
(Current Liabilities - ST Debt**)
** Short-term Debt = notes payable and current portion of long-term debt
Intel Fiscal Year 2000
Cash & Cash Equivalents = $13.8B
Current Assets = 21.2B
Short-term Debt = 0.4B
Current Liabilities = 8.7B
(Current Assets - Cash & Equiv.)
Flow Ratio = ---------------------------------------
(Current Liabilities - Short-term Debt)
= (21.2 - 13.8) / (8.7 - 0.4)
= 0.89
The first part of this will eliminate all but a few select companies, the second even more so. Cross them over and almost no company will be able to meet the test. Still, we want big companies, and we would like them to be in industries that have promising futures, evidenced by above-average growth today. Neither, however, should be taken as hard limits, and be wary of any company that consistently says it's going to grow at 15%+ rates. Be even more wary of CleanAir that is growing at slower rates than its competition.
Intel Fiscal Year 2000
2000 Sales 1999 Sales Growth
$33.7B $29.4B 14.6%
We won't know everything about CleanAir, and sometimes leaderships perceived
by the public as great turn out to be anything but (example: Enron). Still,
you want to try to own companies run by leaders who are honest and who show above-average
skill at increasing the value of people's investments in good times and in bad.
Return
on Invested Capital (ROIC) measures the amount of money CleanAir creates using
its capital base. If CleanAir produces anything below 11% is not providing
enough return to compensate investors for the added risk of owning CleanAir
stock rather than simply buying an index fund comprised of
the S&P 500.
This one is important. Only under extraordinary circumstances would
an investor want to buy a company that is being financed by enormous amounts
of debt. Some debt is good; bunches of debt introduce an enormous risk to investors.Fiscal Year 2004
Cash + Unused Assets + Bldg Adj + Rental Adj
$.2M + $6M -($5.6M -$2.2M) + $2M = $4.8M
$2M + $1M
In the short term, the economy can hammer any individual market. Expect
the stock price of CleanAir and most good companies to get
cut in half at some point. Oftentimes, the sell-off will be unwarranted; Mr.
Market is just playing games with your short-term emotions. Keep your wits about
you. Pull out the
CleanAir Profit Model Guidelines and run through them again.
The CleanAir System
CleanAir
Profit Model
