The Risk-Reward Tradeoff
To buy a stock, you need two things.
First, to feel comfortable that you understand the business model and
its positive prospects, and second, that the current valuation offers
sufficient potential return for the risk. Growing online retailer drugstore.com
needs to be a bit cheaper for Tom Jacobs to buy more shares. Your situation
Jacobs (TMF Tom9)
March 11, 2003
The market's decline has hammered the good businesses along with the
bad. But to separate the opportunities from the traps, one must understand
the business model and the stock's valuation. I took an excited
look at drugstore.com's (Nasdaq:
DSCM) business last week. Today's column picks apart the financial
information to turn the second key of valuation: Is drugstore.com's risk-reward
tradeoff favorable at its current price?
The answer depends on your investing goals, what risks you are willing
to take, and your own understanding of the business and financials. I
hope sharing my thoughts adds to your noodling. (And if you'd like to
learn more about company financials in a fun and very Foolish way, enjoy our
online seminar, Crack
the Code: Use Financial Statements Like a Pro!)
The risk-reward tradeoff
When we check inside the medicine cabinet (hmm, that aspirin's looking
a little dated, now isn't it?),
drugstore.com looks like an improving business with consistently increasing
revenue from skillful acquisitions, key partnerships, growing customer
acquisition, rising gross margins (a relative decline in cost of goods
sold), super inventory turns, reduced expenses of all kinds, declining
burn and Flow
Ratio, and a negative cash conversion cycle (as you'd expect from
an online retailer). Whew, I'm out of breath.
But it's not yet cash flow positive from operations, and that may stop
an investor right there. No matter how good the signs, there's risk in a business that
cannot yet fund its operations entirely from operating cash flow and must
still dip into its reserves. If you want to take on that risk, the potential
gain must be worth it.
Let's examine the extent of the risk that the company will never be self-funding,
and then the potential payoff.
Even if a company is not yet cash flow positive from operations, it
can be. If I see strongly rising revenues, declining cash burn, and enough
cash, there's an excellent possibility this momentum will lead to self-funding
growth long before cash runs out.
drugstore.com sports strongly rising revenues. Sales are growing rapidly,
with year-over-year gains from 26% to 40% in the last four quarters. Some
of this growth has come from acquisitions, but it's very positive that
the company has maintained and slightly increased gross margins (gross
profits divided by revenues, from the income statement).
Quarter YOY* Gross Flow
Ending Revs. Change Margins Ratio
12/02 $55.0 26% 20% 0.80
09/02 47.4 35% 20% 0.84
06/02 47.6 40% 19% 0.85
03/02 43.9 34% 19% 1.04
12/01 43.5 -- 19% 1.14
09/01 35.0 -- 17% 1.43
06/01 34.0 -- 16% 1.38
03/01 32.8 -- 15% 1.36
*Year over year; current Q vs. same Q a year ago
Note the stable and increasing gross margins and declining Flow Ratio.
These are two indicators that even though revenues are growing in part
through acquisitions, they are well managed. Despite competition from
chain drugstores, mass-market retailers, supermarkets, warehouse clubs,
and independent drugstores, the company is more than holding its own and
Cash burn down
There are many ways to define cash burn, but I use cash from
operations minus tax benefit from stock options and capital expenditures
-- the same measure I use for free cash flow. Cash burn is declining fast:
Quarter Cash Cap. Cash Cash &
Ending Ops. Ex. Burn Equivalents
12/02 -- -- -$1.0* $61.9
09/02 -$2.9 -$0.6 - 3.5 62.2
06/02 - 4.5 - 0.2 - 4.7 66.0
03/02 - 7.7 - 0.1 - 7.8 70.8
12/01 - 8.7 - 0.4 - 9.1 78.7
09/01 -11.4 - 0.2 -11.6 84.4
06/01 -12.3 - 0.2 -12.5 100.6
03/01 -15.0 - 0.2 -15.2 113.7
Cash burn last quarter appears to be pretty close to a paltry $0.3 million,
but if you take away cash received from lease financing, it's $1 million.
Still part of an excellent declining trend. The company appears very likely
to turn cash-flow positive from operations, with most of its $61.9 million
in cash and equivalents still available for management to use advantageously.
The key: Can management continue to slash or at least contain expenses?
On its latest conference call, management rightly trumpets its
success in strangling expenses. They are down everywhere, here expressed
as percentage of revenues:
Expense as % of Revenues
Expense Item Q4 '01 Q1 '02 Q2 '02 Q3 '02 Q4 '02
COGS 81.5% 80.6% 80.5% 80.3% 79.6%
and sales 29.6% 26.7% 21.7% 13.7% 12.3%
order proc'g 16.0% 15.2% 13.6% 14.0% 12.8%
& content 7.9% 8.0% 6.9% 5.3% 4.6%
Seq. 16.2% (0.6%) 8.4% 1.1% --
Y-O-Y 26% 35% 40% 34% --
Could these declining expenses be any more encouraging? My household
finances would love to look like this. It's clear that while sales grow,
management reduces every associated cost. Any company would be proud of
this trend, which is a crucial part of the momentum toward profitability
and free cash flow.
What about the other guys?
When we line up drugstore.com's gross and operating margins,
and inventory turns against other discount and drugstore retailers on
and offline (and both!), there is more good news. For the most recent
Gross Operating Inventory
Margins Margins Turns
BJ's Wholesale Club 11.0% 3.6% 8.1
Costco 12.4% 2.9% 10.8
Overstock.com 18.7% -11.9% 6.2
drugstore.com 19.8% -22.1% 26.5
Wal-Mart 22.2% 5.2% 7.5
Rite Aid 23.4% -2.8% 5.3
CVS 25.1% 5.8% 4.5
Amazon 25.2% 1.6% 19.0
Walgreen's 26.7% 5.7% 5.9
Sportsman's Guide 33.0% 3.7% 5.2
drugstore.com's gross margins are decent but unspectacular, and without
profits, its operating margins are the worst. But like Amazon
AMZN), it sure does turn that inventory, baby. The faster
you turn your inventory around, the less likely you are to have the markdowns
that kill your gross margins. This is a really good indicator of how well
drugstore.com's managers run the business and why increasing revenues
appear practically guaranteed to bring increasingly happy results.
I ran a discounted
cash flow (DCF) valuation model for 20 years with a terminal period,
with low, medium, and high assumptions for growth in free cash flow (operating
cash flow minus tax benefit from stock options minus capital expenditures).
Then I mixed in 2% annual net dilution (grants minus cancellations) from
stock option grants and applied an 11% discount rate representing my required
rate of return from the investment, in view of the risk. With a very predictable
business, I might require a lower return, or 8%, and for a more speculative
business than drugstore.com, 15% or more. I view drugstore.com as somewhere
in the middle, given more and more proof that management manages the business
and cash well.
The company says it will be EBITDA positive in 2003. That's a good prospect, and
free cash flow would follow that in 2004. My model begins with roughly
$3 million in free cash flow in 2004, or $0.04 a diluted share.
Bumps and taxes
Please note that in Year 3 of the low-growth model below, I build
in a speed bump -- something going wrong. I chose a 25% drop in free cash
flow from theoretical loss of the Amazon deal, which is reported to drive
10% to 15% of revenues. And in all three models, I assume that in 2005,
the company's free cash flow (FCF) is reduced because new profits mean
it must pay taxes for 2004 (and thereafter) at a 35% rate.
Here are my assumptions and the results for low, medium, and high free
cash flow growth:
Low Medium High
Years 1-5* 10%** 15% 25%
Years 6-10 7.5% 10% 20%
Years 11-20 5% 6% 12%
Terminal 5% 6% 6%
Present Value FCF $0.38 2.23 3.19
Plus net cash/shr $0.91 0.91 0.91
Intrinsic Value $1.29 3.14 4.10
IV Vs. $3.00 +57% -5% -27%
*FCF reduced to reflect 35% rate for Year 2 for L, M, and H
**25% reduction in Year 2 for business hitting speed bump
Remember that when you get a result using DCF, that result says that
as long as your assumptions hold true, you will achieve your desired returns
at that intrinsic value. Yesterday's $3.00 close is well above the low-growth intrinsic
value, barely below the medium-growth, and a decent discount to the high-growth.
I also perform a reality check to see if the assumptions unstated in
the DCF pass the straight-faced test. Specifically, does the growth projected
lead to revenues that seem possible? My growth assumptions for free cash
flow lead to a ballpark $500 million in revenues in Year 10 under the
medium-growth scenario. It's not farfetched to me that moderate customer
growth could take the company from last year's $200 million to half a
billion or more in 10 years.
Buy, sell, or hold?
The low-growth scenario strikes me as overly conservative, given
management's last eight quarters of excellent cash and business management. I
bought a small holding at $2.38, when the discount to the medium- and
high-growth intrinsic values was better, but today I see a growing business,
fairly valued. To add more shares, I would like to see a discount of 20%
or more to the medium-growth intrinsic value of $3.14 or future quarterly
results that better the calculation.
None of this is a science, and your mileage may vary. You may run, waving
your arms, screaming, "Danger! Danger!" from any company not currently
generating operating cash flow and profits. Perhaps you find a greater
risk that the company could lose key partner Amazon or Rite-Aid
RAD). You may be more or less confident that the company's brand and
customer service reputation should increase revenues and gain market share,
whether overall consumer spending rises or falls.
You may also require a larger or smaller discount to intrinsic value.
Some investors are comfortable buying at or near intrinsic value (or an
average of their projections), while others, such as my colleague Matt
Richey (TMF Matt), prefer a substantial
But I'll bet no matter what, you and I agree that if the company gains
both customers and greater spending per customer, shareholders
might see not only the high-growth scenario, but potentially a whole lot more.
Please join me and other Community members to discuss the company on our
discussion board. Have a most Foolish week!
Tom Jacobs (TMF
Tom9) just got TiVo and loves the different beeps. He sings
along, "Are we not men? We are TiVo!" He owns shares of drugstore.com
and other companies you can find on his profile.
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