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Wednesday, March 17, 1999

An Investment Opinion
by Louis Corrigan

Safeskin's Lessons: Being Safe Not Sorry

Last week's earnings warning from Safeskin (Nasdaq: SFSK), a leading maker of high-quality disposable latex and synthetic medical examination gloves, was a long time coming. The stock had already drifted from $47 1/8 in July to Thursday's close of $18. Still, it was skinned for another 50% loss on Friday and now trades for just $8 3/4. Only a month ago, the company reported its tenth consecutive year of 25% or better growth in revenue, and Chair/CEO Richard Jaffe projected a record FY99. So it's hard to say that one should have avoided -- or even profited from -- the recent massacre. Still, some did, and it's worth highlighting why.

First, a quick review of what's made the once incredibly profitable Safeskin so unsafe looking.

On February 10, the company reported that Q4 sales rose 27% to $63.6 million and EPS followed, up 30% to $0.27 after backing out one-time expenses related partly to relocating a glove-making facility from Malaysia to Thailand. For the year, revenue roared ahead 30% to $237.1 million, pumping EPS up 43% to $1.00. Thanks to a sales mix rich with high-margin synthetic gloves and lower manufacturing expenses, gross margins for the quarter and the year shot up from 44% to 52%. Though juiced up by $92 million in new long-term debt, Safeskin's return on average equity came in at a slick 52.8%.

Then came the warning late last Thursday. Due to "higher than estimated distributor inventory levels and [a] slower-than-anticipated ramp up of orders from new customer contracts," management now sees first quarter sales falling a stunning $28 million below analyst estimates. Earnings per share will slip $0.25 to $0.26 shy of the consensus estimate, which stood at $0.27 before the announcement. For the year, Jaffe said sales "will be lower by approximately an additional $25 million."

At the end of the third quarter, Safeskin delivered extra product to distributors to support an expected increase in sales. "As it turns out," Jaffe said, "there was more inventory in the system at that time than we had previously estimated." Trouble is, the company's critics were all over this problem back in October.

A Once-Friendly Analyst Dissents

We know that sell-side analysts operate under a serious conflict of interest because they get compensated more for the investment banking work they bring to their firms than for the investment value of their opinions. So we place mental asterisks next to bullish comments made by a company's underwriter and pay more attention to the opinions of more disinterested parties. Yet, we also know that sell-side analysts in general don't like to veer from the pack, especially by going negative.

That's why the move on October 29 by analyst Melissa Wilmoth of Salomon Smith Barney (SSB) merited serious attention. Wilmoth downgraded Safeskin from "buy-high risk" to "neutral-high risk" and cut her FY99 EPS estimate to $1.22 from $1.29. SSB took Safeskin public. Yet here Wilmouth was worrying aloud about Safeskin stuffing its sales channel.

When a company is having trouble making its sales number for a quarter, it may offer resellers or customers discounts or favorable payment terms to accept product they don't yet need, even if that steals sales from future quarters. As Wilmoth told her clients in late October, one large distributor had gotten very favorable terms for the first time in a year.

Jaffe and his colleagues denied this. Yet, the wacky balance sheet raised serious questions. Accounts receivable (what the company is owed by customers) rose 89.7% year-over-year and 61.1% sequentially despite just 31.3% higher year-over-year sales and just a 5% sequential revenue gain. Sales were being booked, but distributors just weren't paying as quickly as they usually did. Rising inventories (up 56.8% year-over-year and 11.6% sequentially) added to the picture of channel stuffing. It was enough to make a shareowner wonder whether the industry was slowing down or competition heating up.

Yet, Jaffe asserted that inventories had been too low earlier and that the transition to the new facility in Thailand caused the normal sales cycle to be delayed somewhat, creating merely a short-term increase in receivables. However, as Wilmoth argued in her research note, "These concurrent trends are a classic sign of potential trouble." Boy, was she right!

Accounts Receivable and Inventories Increase Faster Than Sales

The following table shows this enormous sequential increase in receivables and inventory for the third quarter. Though many businesses experience seasonal patterns that make year-over-year comparisons more appropriate, true growth stocks often are expected to deliver stronger sales from one quarter to the next. (Expand window to view table.)

Sales Y/Y Seq. AR Y/Y Seq. Inv. Y/Y Seq.
Q2 58.6 30.5% 10.0% 24.9 13.0% -2.7% 31.2 47.6% 17.9%
Q3 61.6 31.3% 5.0% 40.1 89.7% 61.1% 34.8 56.8% 11.6%
Q4 63.6 27.2% 3.3% 37.7 69.7% -6.0% 35.5 67.0% 1.8%
Y/Y= year-over-year
Seq.= quarter vs. previous quarter
AR = accounts receivable
Inv.= inventories
Sales, receivables and inventories in millions

In most cases, you want receivables and inventories increasing in lock step with sales, preferably a bit more slowly. In Q4, for example, accounts receivable declined by 6% sequentially while inventories rose 1.8% sequentially -- or less than sales increased. This represented a modest improvement, but not enough to counteract or really explain the Q3 surge.

The List of Shorts Grows Long

Month Shares Short Short Ratio

6/98 2.98 million 8.64
7/98 .21 million 6.73
8/98 3.29 million 7.65
9/98 3.57 million 7.44
10/98 3.30 million 5.97
11/98 4.16 million 1.72
12/98 4.95 million 3.50
1/99 5.08 million 5.31
2/99 6.77 million 6.05
(Short ratio = shares short divided by average daily trading volume; also called "days to cover")

While a Safeskin shareowner should have already been concerned by these issues, other investors (or short-sellers) might have discovered the story by tracking monthly short interest figures. A short ratio above 5 indicates significant short-seller interest. Safeskin made that cut long before the Q3 earnings report led the shorts to pile on. The numbers increased in every successive month, including a surge following the Q4 earnings report. (The erratic short ratio numbers were misleading since they merely reflected increased daily trading volume as bulls and bears fought it out.)

Short-sellers can be very wrong, of course, as they have been with many top Internet companies whose business models are only beginning to be proven. Nonetheless, high and growing interest from short-sellers means you should try to track down the bear take and evaluate it -- especially when the company in question has an easily understood business model but a balance sheet that looks out of whack.

Falling Price on Rising Volume and No News

Day Volume High Low Close

03/04/99 357,000 22 1/16 21 1/2 21 3/4
03/05/99 872,500 22 20 1/2 20 11/16
03/08/99 1,705,600 21 19 5/8 19 7/8
03/09/99 2,445,100 19 13/16 17 13/16 19 1/4
03/10/99 2,929,800 19 7/8 17 15/16 18
03/12/99 24,838,600 9 15/16 8 9

As Fools, we don't engage in the mumbo jumbo of technical analysis, with its support levels and moving averages. We're looking to buy businesses at good prices. But a "market signals" approach suggests that markets act with the collective voice of all buyers and sellers and can "tell us" things -- like "the outlook is brighter" or "clouds are on the horizon." Fundamental investors should often take these signals as a call to investigate. Where are the clouds coming from? Will they pass over, or produce a flash flood that will wipe out the college education fund?

The rising volume and falling prices depicted in this table suggest that the market starting seriously entertaining Safeskin's disaster days before the warning came. Did someone in the company inadvertently tip off an institutional investor, who heard a slightly different tone when he asked how things were going? Or did a hedge fund shorting the stock have some particularly compelling discussions with distributors suggesting that Safeskin would finally be skinned? Who knows. Yet, in light of the questions already in the air, the trading action last week suggested investors might have good reason to worry.

Is Safeskin now a value at about 9 times trailing earnings? Maybe, but I wouldn't touch it with latex gloves. First, management has lost credibility, big time. The inventory problem didn't just sneak up on the company, as Jaffe suggested in the earnings warning. Milberg Weiss and friends will hound Safeskin with lawsuits, and perhaps rightly so.

Second, the FY98 numbers don't count now. They aren't literally phony, but investors have to mentally revise them even if the auditors don't. Reported sales definitely outpaced real end-user demand, inflating profits massively. The question is how much. Third, the company's warning mentioned increased price pressures, with gross margins dropping from 52% to perhaps 46%. Lower sales, lower gross margins and a management team you can't trust. No wonder the stock is down 80% since July.

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