The Coca-Cola Company (KO) of the Internet

If there’s one piece of Buffett advice that investors should always live by is to try and invest only in companies with exceptionally high economic goodwill. By that, he means companies that are able to deploy their capital efficiently and have relatively low costs of maintaining their operations. Such companies can deliver their excess cash back to the hands of shareholders.

The ultimate example

When Buffett first bought into The Coca-Cola Company (NYSE:KO) back in 1988, he knew that he found the ultimate capital efficient business. Coke owns around $15 billion in property, plant, and equipment. It has $8 billion in long-term investments and more than $21 billion in cash and working capital. Altogether, that’s about $45 billion in capital. Against these assets, it can borrow roughly $42 billion – that’s long-term debt, receivables, etc. This is capital it doesn’t have to keep in the business because it has such a strong business and reputation, it can borrow at cheap rates. That’s been true, by the way, irrespective of the nominal level of interest rates. The Coca-Cola Company (NYSE:KO)’s real (that is, after tax and after inflation) cost of borrowing is extremely low. On a net basis, Coke runs its entire operation on only $3 billion in capital. And on this $3 billion in net capital, it produces annual cash flows in excess of $9.5 billion. That’s a return of 216% on net tangible capital. That’s a mouth- watering rate of return.

But that high rate of return on capital isn’t reserved only to consumer- brand names such as The Coca-Cola Company (NYSE:KO). From time to time, you can also find such examples in the internet sector.

The Coke of the internet space

Check Point Software Technologies LtdThe company that I wish to discuss makes its money from internet security and operates from Israel. Check Point Software Technologies Ltd. (NASDAQ:CHKP) is a leading provider of software that protects computer networks from malicious attacks. There’s a funny thing about internet security software. Once a business is used to using a specific software of one company, it isn’t likely to change and move to a competitor. I liken it to changing a doctor when you’re sick… you usually don’t want to do that. This competitive edge of Check Point Software Technologies Ltd. (NASDAQ:CHKP) shows up well in the results.

Cash flow

The company is gushing cash. It has grown its free cash flow at an average rate of 16.7% per year over the last 10 years. In fact, Checkpoint is now able to generate an astounding 71 times more cash than it needs to invest back into the business. Fortinet Inc (NASDAQ:FTNT), a fierce rival of Check Point Software Technologies Ltd. (NASDAQ:CHKP), generates only 6 times more cash than it needs to invest back into the business. Now, that’s the beauty of capital efficiency.

Margins

Check Point Software Technologies Ltd. (NASDAQ:CHKP) has an operating margin and profit margin of 55% and 46%, respectively. Just to get a a feel for the numbers, Coke’s margins are half that. These exceptionally high margins have positioned Checkpoint to make the incredible pile of cash that it has been earning. Fortinet Inc (NASDAQ:FTNT), for example, has operating and profit margins of ‘only’ 18% and 12%, less than one third of Checkpoint’s.

But high margins aren’t the whole story – A capital efficient business must be shareholder friendly in order to qualify as a worthy investment.

Shareholder- friendliness

Check Point Software Technologies Ltd. (NASDAQ:CHKP) employs an aggressive share buyback program. The massive free cash that the company generates has allowed it to buy back about 20% of its shares over the past decade, a trend that will likely continue. On the other hand, the company pays no dividend, which is a bad practice in my eyes. In the company’s defense I must add that given the extremely high internal returns it generates (18% return on capital, with zero debt), perhaps this is actually a positive for shareholders. Fortinet, on the other hand, shares this practice of not paying dividends to shareholders but maintains a lower return of only 14%.

The article This Company Is the Coca-Cola of the Internet Space originally appeared on Fool.com and is written by Shmulik Karpf.

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