Analyzing Inventories

I’m going to take a chance of boring you with a lesson in inventory analysis. This is intended to just give you some perspective. This is not a technique for timing a stock purchase, rather, for building a case that is further supported by the price and volume action of a stock.

Although you don’t have to be a forensic accountant to trade stocks successfully, a little detective work can provide valuable clues and possibly tip you off to trouble ahead—or alert you to a favorable situation.

Inventory figures can be found in the published balance sheets of a corporation, which is available in 10-q (quarterly) and 10-k (annual) filings to the Securities and Exchange Commission (SEC) that can usually be found on the company’s website. This is a big plus for investors today. In the 1980s when I first started trading stocks, companies were not required to report inventory figures; now they’re readily available.

With a manufacturer or retailer, inventory and accounts receivable analysis can provide a valuable clue—a “heads up”—as to whether business conditions are likely to improve, or if the favorable times are coming to an end.

In late 2003-2004, the price of copper was going through the roof. This rapid escalation in the price of a raw material, I knew, would enable manufacturers of copper products to pass along a price increase to customers. Any manufacturer that already had high raw material inventories of copper (purchased at previous, lower prices) would be in a position to enjoy expanding profit margins when the price increase was passed along to consumers. My job was to find a company in exactly that position.

By examining the inventory figures in the quarterly reports of several manufacturers, I found my candidate: Encore Wire. It had significant copper inventories at a time when copper prices were rising. It was no surprise when that same stock ended up on my target list as there were other investors looking at the same fundamental factors. With the benefit of my inventory analysis and confirmation on the SEPA® stock analysis as well, I had my potential winner in sight. WIRE turned out to be one of my big winners.

For certain industries, such as in manufacturing, the comparison of inventory and sales is crucial. Specifically, I look at the breakdown of inventory (i.e. finished goods, work in progress, and raw materials) and how each segment relates to the other. The inventory breakdown also provides an important perspective regarding sales. For example, a strong gain in sales may look impressive; however, the company could be pushing on a string if, in fact, inventories are still growing much faster than sales.

The individual components of the inventory are worth looking into. If the finished goods portion of inventories is rising much more rapidly than the raw materials or work-in-progress segments, this could very well mean that product is piling up. Therefore, production will slow because the company has a stockpile of finished goods. If that inventory of finished products is higher depreciable—such as computers or retail goods that go out of fashion—this could spell some trouble ahead. With inventory that’s depreciating, the company will have to cut prices to get rid of it. Plus that aging inventory will compete in the marketplace with newer product lines. Higher trending inventories can lead to mark-downs and write-offs—a scenario ripe for a hit on future earnings, causing the company to report a disappointing quarter.

Keep in mind that the amount of inventory by itself is not that meaningful for your analysis. It’s the trend in inventories versus sales and the percentage increase or decrease within the inventory chain that yield valuable information. Think of inventory as merchandise waiting to be sold. A company tries to anticipate future sales and stocks inventory to meet demand or expected demand.

Under most conditions, inventories should rise and fall in a similar pattern as sales. When inventory grows much faster than sales, it could indicate that the product is not selling very well or that management has misjudged future demand. Both scenarios are likely to be detrimental to earnings.

The more rapidly inventory depreciates the more excess inventory will be detrimental. Companies that control their inventory the best in an environment of falling prices has the potential to hold up best and outperform, especially during an economic downturn.

Dell Computer’s answer to this problem was the “build-to-order” business model, which it pioneered. The model transformed the manufacturing business by lowering inventory stockpiles and decreased the risk of holding depreciating computers. Other companies have since utilized this simple concept even in industries outside the computer business. For Dell, this unique and, at the time, new business model allowed it to capture higher profit margins than its competitors, gain market share, and dominant the computer market during the 1990s.

Dell’s business model is straightforward and logical. Dell takes orders over the phone and through its website. But Dell does not put the computer into production until the order is placed. This dramatically reduced the number of days of inventory held by Dell, and increased the inventory turnover ratio to more than three times that of its rivals.

The reason this concept worked so well in the computer business is because the product is highly depreciable. Virtually all of Dell’s competitors relied on a business model that involved stocking retail stores with merchandise. When business turned down, Dell’s competitors were holding large inventories of merchandise, the value of which was eroding with time. To keep their merchandise from spoiling like fruit in the sun, Compaq, Hewitt-Packard, and Gateway were forced to cut prices to unload their stockpiles. This type of move will show up in inventories, most likely with finished goods rising and trending upwards faster than sales and faster than raw materials.

Not all inventory build-ups are bad. Maybe the company has to fill the shelves of 20 new stores it just opened. The real red flag rises when you see the inventory build-up and it’s either unexplained or the explanation isn’t a good one. If you spot an inventory buildup that’s not explained, you can call the company or go on an investor conference call to ask for an explanation.

On the flip side, if raw materials are suddenly building up, this could be an indication that the company believes business will be picking up. If that’s the case, then sales should show signs of increasing and acceleration shortly afterwards to confirm that the raw material buildup was indeed in anticipation of stronger demand.
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Mark Minervini