EMC's Uncertain Inventory Equation

Chalk up another good quarter for EMC (NYSE: EMC  ) . Sales and earnings were up 14.9% and 27%, respectively, for the fourth quarter and 17.4% and 47%, respectively, for fiscal 2005. Margins expanded by more than 2% in each period. And the company's $931 million in free cash flow was nothing to fret over, either.

That's an impressive array of results, to be sure. And it may help explain why investors are clamoring for EMC shares like a hyperactive five-year-old on a sugar high begging for a can of Coke. The stock was up more than 2% as I wrote this.

But I also can't help wondering if these same investors have properly dug into the financial statements. Because if they had, they would have noticed a somewhat troubling rise in inventory vs. sales over the last several quarters. The trend continued in Q4. Have a look at the year-over-year numbers:

Quarterly Change

3/05

6/05

9/05

12/05

Sales

+20%

+19%

+17%

+15%

Inventory

+9%

+28%

+38%

+41%

Data provided by Fool.com and earnings press releases

This, however, doesn't tell the whole story. More important is to understand whether finished goods inventory is growing faster than sales. If so, drives, subsystems, and arrays may be sitting in a warehouse somewhere waiting to be sold.

So, how has EMC done? We don't yet know for Q4, but data covering the trailing 12 months prior may lend some insight. See below:

Quarterly Change

12/04

3/05

6/05

9/05

Sales

+27%

+20%

+19%

+17%

Finished goods inv.

-30%

+18%

+57%

+89%

Data provided by earnings press releases and filings with the SEC.

Ouch. During Q2 and Q3, EMC experienced massive buildups of finished inventories that have yet to be sold off. It's worth noting that in its quarterly filings, EMC warned it would have a larger stockpile. But that growth is, at least at the moment, vastly outpacing sales. And that creates the additional risk of an inventory writedown in the future. Probably not of the same scale that buried Cisco (Nasdaq: CSCO  ) and Lucent (NYSE: LU  ) during the bubble, but not good, either.

The question, then, is whether investors are being compensated (i.e., a cheaper stock) for the added risk. Not anymore, in my opinion. The stock trades for 35 times free cash flow, yet FCF declined year over year. And even though it sold out of its new DMX-3 arrays in Q4 -- a good sign -- my estimates indicate that EMC's Q4 finished goods inventory doubled year over year. That's at least understandable because of the new product line, but still not good news.

In short, EMC's sales and inventory are simply too far out of step. I won't be buying the stock till the rhythm returns.

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Fool contributor Tim Beyers thinks storage is sexy. Yeah, we think it's weird, too. Tim didn't own shares in any of the companies mentioned in this story at the time of publication. You can find out what is in his portfolio by checking Tim's Fool profile. The Motley Fool has an ironclad disclosure policy.


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