Qualiport

But who's left in contention?

Are they Qualiport material?

Over the past few weeks, we have been slowly but surely learning about our 3 chosen consumer branded products companies -- Unilever, Reckitt & Colman and finally, Cadbury Schweppes. We will use today's roundup to go back and recap on the positive and negative points of each of the contenders. The one thing to always remember is that there is no perfect company, no matter how much we would like there to be one. As I have said previously, the closest I think we come to it in this country is Rentokil Initial, whilst in the US it would be Coca-Cola. But, that's just one Fool's view, and someone else may think Sage and Amazon.com, respectively, are their ideal companies. You can find the link to the Qualiport's version of the ideal company by clicking here. As we recap the strengths and weaknesses of our 3 companies, I will refer to the 10 criteria to see how each company weighs up.

Reckitt & Colman

Reckitt & Colman's Plus Points

• high and increasing operating margins.
• strong brand names.
• ability to increase the profitable pharmaceutical business.
• having undergone "massive organisational changes" in the last few years, management may now be in a position to concentrate on growing the core business.
• global opportunities.

Reckitt & Colman's Minus Points

• anaemic sales growth over past 4 years.
• changes in the company may have had a destabilising affect on employees.
• highish debt level and low free cash flow.

As I was going through the Reckitt & Colman review last week, I was thinking to myself that they weren't a bad company. They had good brands, focussed management and a clear vision of the future. It was only when I got to the numbers that things started looking not so clever. In the past 5 years, their sales have grown by a compounding annual growth rate (CAGR) of 1.2% and adjusted EPS by a CAGR of 5.6%. This is hardly inspiring stuff.

What really put me off the company, however, was their current debt level and lack of a lot of free cash flow. The generation of cash is ultimately what makes or breaks a company. Cash in the bank means that a company can grow the business organically or by acquisition, and they can also return cash to shareholders by means of increasing dividends or share buybacks.

Reckitt & Colman have net debt of £536m and interest cover of 6.5 times. This is not particularly demanding, and the company could stretch that further if they wanted to. Granada has interest cover of 3.6 and British Aerospace's interest cover is 3.0. What puts me off is that Reckitt & Colman are not actually generating much free cash flow. Capital expenditure is currently high, but this additional expenditure is not being translated into significant earnings or sales growth. That is not to say that one day down the track it will not manifest itself in this way, but at the moment there are no visible signs of that happening. The lack of free cash flow also must limit the company's acquisition potential and aspirations.

I can't feel comfortable investing in Reckitt & Colman, and I am going to eliminate them from Qualiport contention. They pass many of the quality company criteria, but fall down at a couple of very important hurdles. You have to be comfortable when buying a part ownership of any company, and I can't feel great about investing in Reckitt & Colman. I would be apprehensively checking their share price every day and at results time would turn straight to the cash flow statement to make sure nothing was amiss.

Good-bye Reckitt & Colman -- we wish you well, although our money won't be riding with you.

Cadbury Schweppes

Cadbury Schweppes Plus Points

• strong and increasing margins.
• well recognised brand names, some of which lead their markets, particularly in confectionery.
• generates free cash flow.
• focussed, targeted management using the "Managing For Value" theme.
• global growth potential.

Cadbury Schweppes Minus Points

• not the market leader in either beverages (behind Coca-Cola and Pepsi) or confectionery (behind Mars and Nestle).
• low return on equity.
• minimal sales growth.
• minimal earnings growth.

Since April 1997, when Cadbury Schweppes went public with their goals to grow shareholder value, the share price itself has gone through the roof. You could therefore say that they've already achieved their main objective, and if I was a shareholder since then, I'd be felling pretty happy sitting on my 88% gain in 18 months.

As I run down the list of charcteristics for the ideal Qualiport company, I'm thinking that Cadbury Schweppes jump most hurdles. They now appear to be a focussed, reasonably well managed company. Whether that was the case prior to then is debatable, but we'll give them the benefit of the doubt at this stage.

Their overall operating margin from continuing operations is 14.5%, up from 13.0% in 1996. The median for FTSE 100 companies is 14.3%. I believe that if a company has strong and increasing operating margins, that is a good indicator of a well managed company that has some sort of competitive advantage.

The beverages portion of Cadbury Schweppes' business is the easiest to compare with other companies. The market leader is Coca-Cola. According to the information presented at their website, in 1997 Coca-Cola achieved operating margins of 26.5%, up a staggering 26% from the 21.0% of 1996. I'm aware that, due to the different accounting methods of the UK and US, that we may not exactly be comparing like-with-like, but it won't be far off. You could deduce from this that either Cadbury Schweppes are a less profitable company than Coca-Cola and will never catch them, or this could give you an idea of the type of margins the company could conceivably achieve.

Over the past 10 years, Cadbury Schweppes have increased their underlying EPS by a compounding annual growth rate (CAGR) of 8.1%. In the same period, trading profit from beverages has grown at an impressive CAGR of 18.7%, and at 10.1% form. Since 1982, the share price has risen from 155p to 927p, giving a CAGR of 11.8%.

Along with Reckitt & Colman, I'm giving Cadbury Schweppes the Qualiport thumbs down. I can't bring myself to invest in a company that is 3rd best, or worse, in its businesses. As I said in the previous reports, Coca-Cola and Pepsi are the leaders in the beverages world, and I can never see a brand like Dr Pepper knocking them off their perch. Sure, the Cadbury Schweppes brands can win market share, but they are never going to be to become the number one. The other two brands are firmly entrenched, and Coca-Cola is gaining market share in the new world. As for confectionery, again companies like Mars and Nestle are ahead of Cadbury Schweppes. Also, over the past 10 years, Cadbury haven't really been able to grow the confectionery side of their business that well. Margins are quite static, and sales are hardly dynamic.

In true Qualiport fashion, we bode farewell to Cadbury Schweppes whilst wishing them every success for the future.

And that leaves...

Unilever

Unilever's Plus Points

• margin improvement. According to Hemmington Scott, the company's normal operating margin has risen every year over the past 5 years, going from 8.7% in 1993 to 9.9% in 1997.
• sale of the speciality chemicals business for US$8m to concentrate on their core product divisions. At the 1997 year end, Unilever had net cash balances of £3.2 billion. This gives the company the firepower to expand both organically and by acquisition.
• expanding into the emerging markets of the world, which account for nearly 90% of the world's population.
• concentrating on building recognised brands, and many of them are the market leaders.
• very strong 1998 first quarter results, easily exceeding analyst expectations, with operating margin up substantially from 7.7% in the corresponding period to 10.0%.
• a strong generator of cash.

Unilever's Minus Points

• the company is in a constant state of change and restructuring. A charge against profits of between £150m and £300m is expected to be made per annum.
• limited sales growth, especially in the developed countries.
• net profit margins less than 5%, indicating a possible lack of competitive strength.
• a difficult company to analyse and to manage.

I'm going to defer judgement on Unilever to next week, when I want to have another closer look at them and some of their numbers. Just because they are the only company left, that doesn't mean I'm automatically going to choose them to move forward to the all important valuation stage. I want to be sure that I consider them a quality company before I go any further. Next Wednesday we'll decide whether they pass most of the quality company tests.

In the meantime, please feel free to share your opinions about the three companies on the Qualiport message board. I've already got some good feedback from the boards. Are Unilever Qualiport material, or am I barking mad by eliminating Reckitt & Colman and Cadbury Schweppes? See you there.

Bruce Jackson (TMF Googly)

Qualiport Numbers

Today's Numbers            Date    19/06/98


          Change     Bid
          pence       £

RTO        0.02      4.18
EMAP      -0.14     12.18
MKS       -0.02      5.55


Rec'd      #    Stock     Buy    Now  % Change  £ Change

19/12/97 1565  Rentokil  2.55   4.18   63.9%     1.63
17/04/98  337  EMAP     11.85  12.18    2.8%     0.33
11/05/98  722  M & S     5.535  5.55    0.3%     0.015


19/12/97 1565  Rentokil 4,040.63  6,541.70  61.9% 2,501.07
17/04/98  337  EMAP     4,043.37  4,104.66   1.5%    61.29
11/05/98  722  M & S    4,052.24  4,007.10  -1.1%   -45.14

Cash                                    33.96

Total                               14,687.42 


                Day    Month    Year    History

Qualiport      -0.2%   -1.6%    51.0%    54.4%
FTSE 100       -1.1%   -2.1%    11.9%    14.5%
FTSE All Share -1.1%   -2.7%    13.1%    15.5%