Skip to main content
Message Font: Serif | Sans-Serif
 
No. of Recommendations: 32
Caution! This is an attempt to put about 80 hours of due diligence and research into a post which can hopefully be
read in about 10 minutes. By normal standards, I guess that's a pretty long time to spend on 1 post. Full
digestion (to include understanding all spreadsheets) could take longer. I hope those who bear with me will
do one or several of the following:

1) Learn something they didn't know before, or
2) Confirm what I think I learned (by agreeing with me on some points), or
3) Add additional learning from their experience, or
4) Point out where my thinking is full of holes.

Up-front Disclosures/Disclaimers: I own MERQ, but am unemotional about it. No cheerleading MERQ, no bashing
competitors. All data is believed to be accurate, but has been manually keystroked and moved around from multiple
sources. If you spot an error, please let me know. Certain conclusions are drawn based on data presented. In
general, that data is NOT statistically significant from a mathematical standpoint, but that data does NOT try to
discredit any "generally accepted" relationships; it is in fact presented to support those relationships.


SUMMARY

. A set of companies (BMCS, CA, MERQ, RATL) representing a subset of the software industry (Web testing and
performance monitoring) is evaluated from a RuleMaker perspective. Each company is compared to its
competition via the Fool's RuleMaker ranker spreadsheet.
. A brief summary of why the companies scored as they did is presented.
. Current RM scores are compared to recent stock performance.
. Past RM scores are compared to recent stock performance.
. Current RM scores are discussed in the context of one valuation metric (PEG), along with some conjecture
about which company (or thought process) might provide the best investment results.

RM Ranker Spreadsheet Details.

. Each company is analyzed in turn against its competitors. (Thanks to Mark of markandsusanv, for his suggestion)
Data is from the Trailing 12 Months (TTM) ended September 30, 2000 for all 4 companies.
. Differences in scoring is driven totally by the financial metrics, and not by any of the subjective metrics.
In other words, I did not try to bias the results by scoring things like "Humor" or "My interest" differently.
. MERQ is my original "company of interest", and this drove the selection of competitors. Competitors were chosen
based on similarity of business as the primary discriminator, but with some secondary consideration given to
excellence in financial metrics and similar magnitude for revenue and market-cap. If one of the other companies
were the original "company of interest", this would probably have led to a different set of competitors.

RM Scoring Results, Year 2000 stock performance, and discussion of scoring differences.

This table summarizes how each company presently scores on the RM ranker, and also shows each company's calendar
year 2000 stock performance:


RM Score Price 1/1/00 Price 12/31/00 Price change

MERQ: 44 $ 109.38 $ 90.25 -17.5%
RATL: 38 $ 49.13 $ 38.94 -20.7%
CA: 32 $ 69.94 $ 19.50 -72.1%
BMCS: 27 $ 79.94 $ 14.00 -82.5%

At first glance, (aside from the ugliness of all of the results) the correlation of stock performance to RM
score makes this game appear way too easy to play.
Put a pin in that thought for now.

The spreadsheets are presented at the end of this post, but highlights are summarized here:

-Overall, MERQ scored the best because all RM financial criteria are well within the target values, and their
financial direction indicates that most of the parameters are still improving. Given the overall market
slide for tech stocks in 2000, -17.5% looks "tolerable".

-RATL comes next, scoring slightly better than MERQ on financial position, but losing points on both
financial direction and monopoly status. Stock performance was also slightly worse than MERQ, losing
almost 21%.

-CA comes next, generally weaker in most categories. Stock performance was a heart-burn causing loss of 72%.

-BMCS comes up last, with slowing revenue growth and decreasing margins being the major culprits. Although not
obvious in the TTM data presented in the spreadsheet, this is especially true when you look at the last 2 quarters
worth of data. And stock performance? I guess I won't go there, but suffice it to say I know how you BMCS
holders feel. (Former PCLN stockholder speaking here)

So why doesn't everyone just follow the RuleMaker criteria and buy higher ranked companies like MERQ?

...hmmmmm...long pause,... thoughtful reflection,... finally the $64 question...DUH!...

What did the RM criteria for these companies look like at the time you would have been trying to make a
purchase decision on 1/1/00?


Well, constructing TTM data that is different from Fiscal reporting years is somewhat difficult, so instead of
answering that question with purity, I constructed a surrogate scenario, using Fiscal Year data for each
company. Using fiscal year data that ends 3/99 for BMCS, CA, and RATL, and 12/98 for MERQ, I reran all the
spreadsheets. I have not included them in this post, but will supply them if requested. Now I can construct a
table based on RM criteria that were captured at two different times, and rank the companies for each time period.

RM Ranking based on "old" data available roughly 18 months ago, compared to "new", most recent data:

Old RM Old RM New RM New RM
Score rank Score rank

BMCS: 50 1 27 4
CA: 28 4 32 3
MERQ: 38 2,3 tie 44 1
RATL: 38 2,3 tie 38 2

Uh-Oh! If you based your decisions solely on RM ranking about 18 months ago, you would have bought BMCS.
And your investment results would have been very good. As long as you got out in about December 99.

I think there are 2 very fundamental "epiphanies" here.

1) The "market" often does a good job of predicting that a company will report good RM metrics.
The converse may or may not occur.

2) Rulemaker metrics alone do not a rulemaker make. In the case of this particular industry and
set of companies, no clear, dominant leader with a sustainable advantage or dominant brand has emerged.
Customers have not established long term relationships with their suppliers, and new companies are
constantly trying to enter the market because there appear to be low barriers to entry, coupled with very
high demand. The competitive landscape is constantly changing, as yesterday's loser leapfrogs today's
leader to become tomorrow's winner. This is very typical with any new emerging technology. Not only is
the leader of this industry unclear, but the future of the industry itself is unclear. Think about
Altair. Or Commodore. Or Stanley Steamer. Or the tons of steel on top of the Empire State Building
designed to dock trans-oceanic zeppelins.

At this point, you may now take the pin out of that thought I asked you to hold onto a while ago, and let it float
where it may, carried away by the winds of change.

As time passes, a clear winner will of course eventually emerge. It may not be one of these companies,
but someone will figure out how to do the software verification job associated with the "internet we haven't
even imagined yet" better than anyone else. Their intellectual properties and years of experience will establish
new barriers to entry. They will surprise and delight their customers. And they will make a pile
of money!
.

So now what. Having a software background in general, and experience in design verification tools in particular
(although in a completely different context), I am convinced that this industry will enjoy above average growth,
and has the potential to give investors above average returns.

But which company has the greatest potential for above average investment returns?

Clearly, today's RM metrics alone can't predict future stock performance. Personally, for companies
that first establish themselves as "potential" rulemakers, I maintain a spreadsheet that currently has about 25
"scoreable" metrics. A lot of these are based on RM stuff, but there are also things like R&D spending, ROE and ROIC,
insider selling, relative strength, and management integrity. But the metric I've been struggling the most with
lately, like a lot of other Fools, is valuation.. There are LOTS of valuation methods. All of them
seem to work sometimes. None of them seem to work all the time. Maybe a combination of metrics,
viewed together, is worth thinking about.

Looking at one simple valuation metric, the PEG ratio, in combination with RM scores, the following table can be
constructed:

RM Price Earnings Expected 5 yr PEG (P/E/G)
Score 1/3/00 TTM 9/00 Growth rate (5 years)
(From Yahoo!)

MERQ 44 $94.32 $.575 40.3% 4.07
RATL 38 $39.08 $.456 36.6% 2.34
CA 32 $21.32 $1.69 16.1% .78
BMCS 27 $15.62 $.65 21.4% 1.12

Wow. Another rough correlation revealed... the market rewards companies that have RM-like metrics
by giving them higher valuations. And this was roughly the same relationship, though of different magnitude,
even before our newly established extension of the holiday season. (Greenspan Day)

Now of course there are margins of error associated with all of these numbers. Sort of like exit polls in Florida.
After all, the RM metrics are somewhat arbitrary. How do we really know that the extra point awarded for
gross margins being above 60% is exactly equivalent in value to the extra point awarded to the flowie for
being less than 1. And how do we know that the analyst growth expectation for MERQ of 40.3% won't actually turn out
to be 41.2%? Or 38.6531%? My point here is that the apparent lack of correlation between RM score and PEG
exhibited by CA and BMCS could be caused by the uncertainty in the data. Or not!

Are we getting any closer to figuring out which company is the better investment?

I can't answer that. But as I stare at the table above, the relationship between the RM scores and PEG ratios of
MERQ and RATL seems "logical". And as long as both companies continue to execute as expected, both may well be
equally good (or bad) investments.

But what about CA and BMCS? Assume for the moment that the data is accurate. CA appears to be the "better"
company as measured by RM criteria, yet has a lower PEG. Maybe this is conceptually the "trading at a discount
relative to its peers" metric that I could trust a bit more than a bare-naked P/E or semi-naked PEG that most of the
analysts talk about. Being retired and therefore somewhat risk averse, I'd want more insight into CA and BMCS's
recent declines before plunking my money down. But what if I could find a set of companies where such a discount existed
between two tier 1 companies. Maybe it has even been present recently in this set of companies. Go look at a
chart of MERQ,

http://quote.fool.com/chart/chart.asp?symbols=MERQ


and it is obvious that there were multiple "good" and multiple "bad" entry points, even for a TA-impaired
guy like me. Maybe some good and bad exit points too. If I were tracking the above table in real time,
would the buy and sell points have been obvious? WHOA! I better update my LTBH investing style in my profile
for even thinking about that.

Well, I should try and finally bring this to a close. I started doing this research to try and decide whether or not
to continue holding MERQ. I have a lot of RM's in my portfolio, and am so confident in most of them that the recent
declines have not really caused any sleep loss. Most are no-brainers if your time horizon is 5 years+. Then there
is MERQ, bought in April. In any "typical week " lately, it moves up or down 30% on no news, and I haven't a clue
whether or not the company will be here 5 years from now. And much to my disappointment, despite the fact that this
exercise has been a learning one, I still don't know with confidence what I will do with my shares.

DARN

This is not the type of post that is put together in one sitting at the computer, or even in one day; so even as I have
been writing it, the landscape is changing. One of my closing thoughts was going to be about the "what if" upside
potential that a low PEG has. And then before I can develop that thought, BMCS goes and executes a small piece of my
"what if" by pre-announcing that they will do better than expectations. Is it a one-off event because analysts have had
to keep ratcheting down expectations? Or is it the start of a multi-year long-term turn-around.

DOUBLE DARN!!!

Ralph

For reference, here are the RM spreadsheets for the Trailing 12 months ending 9/00, in alphabetical order:

For BMCS ****************************************************************************


Financial Analysis Company Being Evaluated Competitor #1 Competitor #2 Competitor #3

BMC Software Mercury Int Rational SW Comp. Assoc.
Current Period Year-ago Period Year-over-Year Current Period Current Period Current Period
TTM9/00 TTM9/99 Growth TTM9/00 TTM9/00 TTM9/00
Income Statement
Sales 1,598,400 1,547,100 3.3% 269,600 684,400 5,957,000
Cost of Goods Sold 243,300 175,600 38.6% 38,600 103,900 338,000
Net Income 164,900 285,600 -42.3% 49,900 90,400 954,000
Shares Outstanding 246,100 253,100 -2.8%

Balance Sheet
Cash & Equivalents 229,800 400,200 -42.6% 617,300 1,020,400 454,000
Current Assets 757,200 906,300 -16.5% 695,900 1,188,000 2,671,000
Short-term Debt 175,000 395,000 -55.7% 0 0 1,319,000
Current Liabilities 755,300 1,048,100 -27.9% 162,400 291,400 2,837,000
Long-term Debt 0 0 No Debt 500,000 500,000 3,676,000

Cash Flow Statement
Operating Cash Flow 499,900 480,700 4.0% 117,900 249,700 1,166,000
Capital Expenditures 194,600 130,800 48.8% 32,800 42,100 134,000

Margins & Ratios . . .
Gross Margins 84.8% 88.6% -3.9 85.7% 84.8% 94.3%
Net Margins 10.3% 18.5% -8.1 18.5% 13.2% 16.0%
Cash-to-Debt 1.31 1.01 29.6% 1.23 2.04 0.09
Net Cash 54800.0 5200.0 953.8% 117300.0 520400.0 -4541000.0
Fool Flow Ratio 0.91 0.77 17.3% 0.48 0.58 1.46
Cash King Margin 19.1% 22.6% -3.5 31.6% 30.3% 17.3%


Continue Here

Ranking Rule Makers

1) Brand Points (0-1) 3) Financial Direction Points (0-3)
Familiarity 0 Sales Growth 0
Openness 1 Gross Margins 0
Optimism 1 Net Margins 0
Legitimacy 1 Shares Outstanding 3
Inevitability 1 Cash-to-Debt 2
Solitariness 0 Fool Flow Ratio 0
Humor 0 Expansion Potential 2
Subtotal 4 Subtotal 7

2) Financial Location Points (0-2) 4) Monopoly Status Points (0-4)
Mass Market Habit 1 Gross Margins 0
Gross Margins 2 Net Margins 0
Net Margins 2 Net Cash 4
Cash-to-Debt 1 Fool Flow Ratio 0
Fool Flow Ratio 2 Convenience 2
Your Interest 1 Subtotal 6
Subtotal 9
5) Your Enjoyment 1

Total Score 27 Fourth Tier


For CA: ******************************************************************************

Financial Analysis Company Being Evaluated Competitor #1 Competitor #2 Competitor #3

Comp. Assoc. Mercury Inter. BMC Software Rational SW
Current Period Year-ago Period Year-over-Year Current Period Current Period Current Period
TTM9/00 TTM9/99 Growth TTM9/00 TTM9/00 TTM9/00
Income Statement
Sales 5,957,000 4,925,000 21.0% 269,600 1,598,400 684,400
Cost of Goods Sold 338,000 288,000 17.4% 38,600 243,300 103,900
Net Income 954,000 715,000 33.4% 49,900 164,900 90,400
Shares Outstanding 592,000 555,000 6.7%

Balance Sheet
Cash & Equivalents 454,000 356,000 27.5% 617,300 229,800 1,020,400
Current Assets 2,671,000 2,361,000 13.1% 695,900 757,200 1,188,000
Short-term Debt 1,319,000 896,000 47.2% 0 175,000 0
Current Liabilities 2,837,000 2,761,000 2.8% 162,400 755,300 291,400
Long-term Debt 3,676,000 4,870,000 -24.5% 500,000 0 500,000

Cash Flow Statement
Operating Cash Flow 1,166,000 1,708,000 -31.7% 117,900 499,900 249,700
Capital Expenditures 134,000 278,000 -51.8% 32,800 194,600 42,100

Margins & Ratios . . .
Gross Margins 94.3% 94.2% 0.2 85.7% 84.8% 84.8%
Net Margins 16.0% 14.5% 1.5 18.5% 10.3% 13.2%
Cash-to-Debt 0.09 0.06 47.2% 1.23 1.31 2.04
Net Cash -4541000.0 -5410000.0 N/A 117300.0 54800.0 520400.0
Fool Flow Ratio 1.46 1.08 35.8% 0.48 0.91 0.58
Cash King Margin 17.3% 29.0% -11.7 31.6% 19.1% 30.3%


Continue Here

Ranking Rule Makers

1) Brand Points (0-1) 3) Financial Direction Points (0-3)
Familiarity 0 Sales Growth 3
Openness 1 Gross Margins 3
Optimism 1 Net Margins 3
Legitimacy 1 Shares Outstanding 0
Inevitability 1 Cash-to-Debt 2
Solitariness 0 Fool Flow Ratio 0
Humor 0 Expansion Potential 2
Subtotal 4 Subtotal 13

2) Financial Location Points (0-2) 4) Monopoly Status Points (0-4)
Mass Market Habit 1 Gross Margins 4
Gross Margins 2 Net Margins 2
Net Margins 2 Net Cash 0
Cash-to-Debt 0 Fool Flow Ratio 0
Fool Flow Ratio 0 Convenience 2
Your Interest 1 Subtotal 8
Subtotal 6
5) Your Enjoyment 1

Total Score 32 Third Tier



For MERQ: ********************************************************************

Financial Analysis Company Being Evaluated Competitor #1 Competitor #2 Competitor #3

Mercury Interactive Rational SW BMC Software Comp. Assoc.
Current Period Year-ago Period Year-over-Year Current Period Current Period Current Period
TTM9/00 TTM9/99 Growth TTM9/00 TTM9/00 TTM9/00
Income Statement
Sales 269,600 168,600 59.9% 684,400 1,598,400 5,957,000
Cost of Goods Sold 38,600 24,300 58.8% 103,900 243,300 338,000
Net Income 52,200 26,750 95.1% 90,400 164,900 954,000
Shares Outstanding 92,530 85,920 7.7%

Balance Sheet
Cash & Equivalents 617,300 153,000 303.5% 1,020,400 229,800 454,000
Current Assets 695,900 203,700 241.6% 1,188,000 757,200 2,671,000
Short-term Debt 0 0 No Debt 0 175,000 1,319,000
Current Liabilities 162,400 75,600 114.8% 291,400 755,300 2,837,000
Long-term Debt 500,000 0 Initiated Debt 500,000 0 3,676,000

Cash Flow Statement
Operating Cash Flow 117,900 47,100 150.3% 249,700 499,900 1,166,000
Capital Expenditures 32,800 13,000 152.3% 42,100 194,600 134,000

Margins & Ratios . . .
Gross Margins 85.7% 85.6% 0.1 84.8% 84.8% 94.3%
Net Margins 19.4% 15.9% 3.5 13.2% 10.3% 16.0%
Cash-to-Debt 1.23 No Debt! Initiated Debt 2.04 1.31 0.09
Net Cash 117300.0 153000.0 -23.3% 520400.0 54800.0 -4541000.0
Fool Flow Ratio 0.48 0.67 -27.8% 0.58 0.91 1.46
Cash King Margin 31.6% 20.2% 11.3 30.3% 19.1% 17.3%

Continue Here

Ranking Rule Makers

1) Brand Points (0-1) 3) Financial Direction Points (0-3)
Familiarity 0 Sales Growth 3
Openness 1 Gross Margins 3
Optimism 1 Net Margins 3
Legitimacy 1 Shares Outstanding 0
Inevitability 1 Cash-to-Debt 2
Solitariness 0 Fool Flow Ratio 3
Humor 0 Expansion Potential 2
Subtotal 4 Subtotal 16

2) Financial Location Points (0-2) 4) Monopoly Status Points (0-4)
Mass Market Habit 1 Gross Margins 0
Gross Margins 2 Net Margins 4
Net Margins 2 Net Cash 4
Cash-to-Debt 1 Fool Flow Ratio 4
Fool Flow Ratio 2 Convenience 2
Your Interest 1 Subtotal 14
Subtotal 9
5) Your Enjoyment 1

Total Score 44 Second Tier


For RATL: *****************************************

Financial Analysis Company Being Evaluated Competitor #1 Competitor #2 Competitor #3

Rational Software Mercury Inter BMC Software Comp. Assoc.
Current Period Year-ago Period Year-over-Year Current Period Current Period Current Period
TTM9/00 TTM9/99 Growth TTM9/00 TTM9/00 TTM9/00
Income Statement
Sales 684,400 479,700 42.7% 269,600 1,598,400 5,957,000
Cost of Goods Sold 103,900 68,900 50.8% 38,600 243,300 338,000
Net Income 90,400 73,000 23.8% 49,900 164,900 954,000
Shares Outstanding 205,900 187,900 9.6%

Balance Sheet
Cash & Equivalents 1,020,400 266,400 283.0% 617,300 229,800 454,000
Current Assets 1,188,000 405,800 192.8% 695,900 757,200 2,671,000
Short-term Debt 0 0 No Debt 0 175,000 1,319,000
Current Liabilities 291,400 168,100 73.3% 162,400 755,300 2,837,000
Long-term Debt 500,000 0 Initiated Debt 500,000 0 3,676,000

Cash Flow Statement
Operating Cash Flow 249,700 91,100 174.1% 117,900 499,900 1,166,000
Capital Expenditures 42,100 17,800 136.5% 32,800 194,600 134,000

Margins & Ratios . . .
Gross Margins 84.8% 85.6% -0.8 85.7% 84.8% 94.3%
Net Margins 13.2% 15.2% -2.0 18.5% 10.3% 16.0%
Cash-to-Debt 2.04 No Debt! Initiated Debt 1.23 1.31 0.09
Net Cash 520400.0 266400.0 95.3% 117300.0 54800.0 -4541000.0
Fool Flow Ratio 0.58 0.83 -30.6% 0.48 0.91 1.46
Cash King Margin 30.3% 15.3% 15.1 31.6% 19.1% 17.3%


Continue Here

Ranking Rule Makers

1) Brand Points (0-1) 3) Financial Direction Points (0-3)
Familiarity 0 Sales Growth 3
Openness 1 Gross Margins 2
Optimism 1 Net Margins 1
Legitimacy 1 Shares Outstanding 0
Inevitability 1 Cash-to-Debt 2
Solitariness 0 Fool Flow Ratio 3
Humor 0 Expansion Potential 2
Subtotal 4 Subtotal 13

2) Financial Location Points (0-2) 4) Monopoly Status Points (0-4)
Mass Market Habit 1 Gross Margins 0
Gross Margins 2 Net Margins 0
Net Margins 2 Net Cash 4
Cash-to-Debt 2 Fool Flow Ratio 4
Fool Flow Ratio 2 Convenience 2
Your Interest 1 Subtotal 10
Subtotal 10
5) Your Enjoyment 1

Total Score 38 Third Tier


Print the post  

Announcements

What was Your Dumbest Investment?
Share it with us -- and learn from others' stories of flubs.
When Life Gives You Lemons
We all have had hardships and made poor decisions. The important thing is how we respond and grow. Read the story of a Fool who started from nothing, and looks to gain everything.
Contact Us
Contact Customer Service and other Fool departments here.
Work for Fools?
Winner of the Washingtonian great places to work, and Glassdoor #1 Company to Work For 2015! Have access to all of TMF's online and email products for FREE, and be paid for your contributions to TMF! Click the link and start your Fool career.