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- Check Balance Sheet Red Flags
The last time that I looked; casual footwear maker Crocs’ shares were
changing hands for around $10 per share, roughly
79% below where they closed on November 1. To
put those numbers in perspective, $1,000 invested in Crocs on November 1
would be worth $209 today.
I picked November 1 because that was the first chance that shareholders
had to react to Crocs’ September quarter earnings report. That report
included at least one“ red flag” warning that holding Crocs’ shares was
risky business.
First Loss Often Best Loss
It’s understandable that shareholders would have been reluctant to
sell. Crocs’ shares tumbled on November 1 because the maker of ugly, but
colorful clogs hadn’t raised its December 2007 quarter sales and earnings
forecasts as much as analysts had expected.
But, as many of us have learned the hard way, your first loss is often
your best loss. Crocs’ closed at $27 on February 20, 2008, the day after
Crocs reported its December 2007 quarter results. That was a 42% drop from
November 1.
By then, many pundits were advising buying Crocs, saying that its selloff
had been overdone and its shares were due for a recovery. But those
pundits hadn’t done their homework. This time, Crocs’ just released
December quarter report contained two “red flags” signaling future
problems. Those were worth heeding. On April 15, Crocs released its March
quarter results triggering another selloff. Anyone who followed the
pundits’ advice and bought on February is down around 60%.
Detecting the “red flags” that I’ve mentioned isn’t difficult. However,
you will need to dust off your calculator (I’ll give you
step-by-step instructions).
I’ll explain why these “red flags” work before I get into the details.
Do Trees Grow to the Sky?
Small companies like Crocs often experience rapid growth as
potential customers discover their products. During that period, everybody
involved, investors, stock analysts, even company executives, believe that
growth rate will continue for the foreseeable future. The share price
reflects those expectations. But, it’s impossible to maintain early-stage
growth rates forever. Eventually growth slows and the share price tumbles.
The “red flags” I’ve mentioned are often you first clue that growth is
slowing. You can find them by making a couple of calculations using data
included in a firm’s quarterly report press release.
First Clue: Inventory
Crocs’ first “red flag,” which involved inventory levels, appeared in its
September 2007 report. At first, Crocs couldn’t keep up with demand for
its footwear and inventories (stock on hand) were low. However, by last
summer, Crocs caught up and inventories began to pile up. In essence,
Crocs was manufacturing more product than its customers wanted to buy.
The balance sheet financial statement lists the inventory value at the end
of the quarter. To avoid seasonality variances, it’s best to compare the
current inventory to the year-ago figure. Often, the press release also
lists the year-ago figures. If not, you can find them on the financial
statements shown on Yahoo (finance.yahoo.com),
MSN Money (moneycentral.msn.com)
and on many other sites.
Normally, inventories would track sales. That is, if sales doubled over
the past year, so would inventories. It’s a “red flag” when inventories
rise much faster than sales. We’ll find out if that happened by computing
the current inventory percentage of quarterly sales and comparing it to
the year-ago figure. For example, the ratio would be 50% if inventories
are $10 million, and the last quarter’s sales totaled $20 million
(compute that on your calculator by entering the inventory
figure, press the “divide” symbol, enter the sales number, then press “%”).
If you had done that using the September 2007 report, you would have found
that September 2007 inventories were 76% of sales vs. 44% at the end of
the year-ago quarter. Consider a 15% increase (e.g. from 40% to 46%) as a
“red flag.” In the Crocs example, inventories vs. sales increased by 73%
(divide 76 by 44, press “%” and then subtract 100).
Using the December quarter figures, the ratio increased by 45%, still a
solid “red flag.”
Next Clue: Receivables
Instead of demanding cash on delivery, most firms give their customers a
predetermined time, say 30 days, to pay for the goods. The amounts owed by
customers are termed accounts receivables.
Similar to inventory levels, receivables usually track sales. However,
when sales lag expectations, a company will often offer longer payment
terms, say 60 days instead of 30 days, to encourage customers to order
more goods. When that happens, receivables rise faster than sales.
Compare receivables to sales the same way that as I described for
inventories. Using the September report, receivables vs. sales increased
15% compared to September 2006, a borderline “red flag.” However, by the
time the December 2007 quarter numbers were out, the figure was 17%,
firmly in “red flag” territory.
In the stock market, nothing works all the time. That’s the case for these
“red flags.” Sometimes you’ll detect “red flags,” but nothing bad happens.
Other times, stocks fall short at report time without any warnings from
the financial statement. However, the existence of the “red flags” that
I’ve described signals added risk. Savvy investors know that not losing
money is more important than maximizing profits.
published 4/27/08 |
