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 may differ.

By Tom 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 cash 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.

Sales up
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 making inroads.

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?

Declining 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%   
Operating 
  Expenses:
Marketing
  and sales    29.6%  26.7%  21.7%  13.7%  12.3%
Fulfillment &
  order proc'g 16.0%  15.2%  13.6%  14.0%  12.8%
Technology
  & content     7.9%   8.0%   6.9%   5.3%   4.6% 
Sales Growth 
   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 quarter:

                   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 (Nasdaq: 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.

Valuation
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 (NYSE: 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 discount.

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 E-Commerce 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. Motley Fool investment writers are investors who write for investors.

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