A Red Flag to Watch

Key to any investing strategy is the ability to find red flags in company financials. They can alert you to potential problems with a business that may lead you to sell or not buy (or maybe even short) a company you are considering.

One indicator is accounts receivable growing faster than sales, perhaps the greatest of the quality of earnings warnings that there is trouble ahead. If a company is collecting payments at a lower rate than sales, it's a possible sign that customers are hurting, or the company is extending too-favorable credit terms or discounts to customers.

Five minute check up
For a quick look at any company's accounts receivables versus sales trend, take the sequential (most recent quarter against the one before, ex. Q2 vs. Q1) and year-over-year (most recent quarter versus same quarter a year ago, ex. Q2 2003 vs. Q2 2002) percentage change in sales. Then compare that to the sequential and year-over-year change in accounts receivable for the same periods. You can find accounts receivable on the balance sheet of any quarterly report (10-Q) filed with the SEC, and sales (or revenues) on the top line of the income statement, also often called the statement of operations.

In January, I applied this screen and up popped software maker Intuit (Nasdaq; INTU). Intuit's sales for the quarter ending Oct. 31, 2002 climbed 34.5% year-over-year while accounts receivable grew 184%. Sales rose 14% sequentially but accounts receivables ballooned 116%. Not good.

"Wait a minute," you say, "Tom, it's a seasonal business -- Intuit's revenues are lowest in Q4 ending in July and the highest in Q3 ending in April. So sequential information doesn't tell us a lot, does it?"

Au contraire, mon Fool. That might be true were you examining one element alone -- sales or inventories. Think of it this way. Your lemonade stand's sales may slow from the summer quarter sequentially to the fall quarter, but there is no reason that customers should be any more recalcitrant in paying. And if you are secretly granting credit or giving discounts to prop up sales figures, your stockholders are not going to be happy when they find out.

On March 20, the company revised revenue forecasts lower and the stock plummeted 24%. It's now about 7% under its pre-drop $50.89. I felt a little pride in my hypothesis, except that as far as I could see, Intuit's problems had nothing to do with inability to collect. (Bye-bye, pride!).

Then what?
With three more quarters, we find a mixed picture. In Q2, accounts receivable actually fell while sales rose, though their growth exceeded that of sales year-over-year by large margins again in Q3 and Q4:

            (in millions except percentages)          Accounts Receivable      SalesQuarter   2003   2002  Change 2003  2002  ChangeQ4 July   $ 88   $ 54   63%   $245  $187   21%Q3 Apr    $120   $ 69   73%   $635  $491   29%Q2 Jan    $244   $263   (7%)  $558  $476   17%    Q1 Oct    $122   $ 43  184%   $213  $158   35%

Sequentially there are two bad quarters and two good quarters -- quarters where accounts receivable grew slower than sales, or even declined [Author note--this table was corrected 9/16]:

  Quarter   A/R*    Sales Q4 July   (27%)   (61%)Q3 Apr    (51%)    14%Q2 Jan    100%    162%    Q1 Oct    126%     14%
*Accounts receivable.

Viewed as a percentage of sales, accounts receivable are higher year-over-year for three of the last four quarters, but not enough to call for a Proclamation of Doom:

       A/R % of SalesQuarter  2002  2003  Q4 July   29%   36%Q3 Apr    14%   19%Q2 Jan    55%   44%Q1 Oct    27%   57%

In fact, I'm wondering if Intuit might be a value. It's growing revenues at rates of 17%-35%, and selling for an enterprise value to trailing-12-months free cash flow (FCF) multiple of 14 and market cap to FCF ratio of 12. To the watch list with you, Intuit! It merits more research -- at least to find out why the SEC filings have different numbers than several online sources.

Some of you Intuit shareholders may be thinking, well then, why not pick on some debt laden rust bucket instead of a software company with high margins showing terrific sales growth that might be undervalued?

Four suspects
Great idea! To close, here are some companies with accounts receivable way up relative to sales, both sequentially and year over year from the most recent quarter. Just as we've seen with Intuit, this is a sign to look more closely. I screened out financial companies, REITs, anything not trading on the NYSE, Nasdaq, or AMEX, and ADRs, and companies with enterprise values under $100 million.

Four particularly bad ones that show up are Multimedia Games (Nasdaq: MGAM  ) , Atlantic Coast Airlines (Nasdaq: ACAI  ) , bebe stores (Nasdaq: BEBE  ) , and ESS Technology (Nasdaq: ESST  ) :

                            Q1 v. Q2*  Q1 v. Q5*Company                  A/R  Sales  A/R   SalesMultimedia Games        141%    7%   242%   22%Atlantic Coast Airlines 188%   11%   138%   21%bebe stores             229%  (31%)  133%   (3%)ESS Technology          181%   (7%)  119%  (64%)*Q1 = most recent quarter, and so on.

As shocking as these numbers are, alone they don't say sell or even short -- but without a darn good explanation, they may. If any of you are shareholders of these companies and can provide some feedback, please email me at TomJ@Fool.com. If I receive any persuasive analysis, I'll put it in a future column.

For more on this and other red flags -- what they mean and how to research them -- check out Plan of Attack and Hidden Red Flags, and yesterday's short take on inventory.

Have a most Foolish week, and thanks for reading!

Like combing through financial statements? Want someone else to do it for you? Take a free test drive ofTom Gardner's Motley Fool Hidden Gems.

Senior Analyst Tom Jacobs reports that it's 63 degrees and fair in Riga, Latvia, the Paris of the Baltics. He owns no shares of companies mentioned in this column but does own others disclosed publicly in his profile. We happy Motley Fools are investors writing for investors.


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