Don't Let This Happen, Cree

Many investors, especially during earnings season, seem to focus on the income statement. How much revenue was there? How much net income was there? Yet it's the balance sheet that actually tells us a lot about how the company is doing and what it's likely to be doing in the not too distant future. Today, I'll focus on two balance-sheet line items: accounts receivable (A/R) and inventories, and how they relate to sales.

In Thornton O'Glove's book, Quality of Earnings -- a compilation of lessons learned while writing the Quality of Earnings Report, "Wall Street's most exclusive newsletter" -- he calls the analysis of A/R and inventory growth relative to sales the "best method" to get ahead of Wall Street analysts.

One of these simple ploys -- the best method I have ever discovered to predict future downwards earnings revisions by Wall Street security analysts -- is a careful analysis of accounts receivables and inventories. Learn how to interpret these ... a larger than average accounts receivable situation, and/or a bloated inventory. When I see these, bells go off in my head.

If A/R goes up significantly faster than sales, then the company could be stuffing the channel, pulling sales in from the future. That can be done for only so long before customers cry "Enough!" and stop buying for a while. Then the company ends up missing revenue and earnings and the stock price gets whacked.

It's similar for inventory. If that is going up significantly faster than sales, that could mean demand is slowing down and a big inventory writedown might be coming. Or, sales will be hurt when large markdowns are used just to clear out inventory.

I'm not talking about normal business cycle stuff. Many retailers build up inventory before the holiday season to meet expected demand. That's normal. What I'm looking for is when there's a big disconnect between the growth of sales and the growth of A/R or inventory. That's what catches my eye and makes me dig a bit deeper to see what's going on.

So let's apply this to Cree (Nasdaq: CREE  ) , a manufacturer of LED, power, and radio frequency products. Here's what the company has reported for the latest four-quarter period, and for the latest two year-over-year periods. I've also included a couple of others for comparison's sake.

Metric	Cree	Veeco Instruments (Nasdaq: VECO  )	Philips Electronics (NYSE: PHG  )
Revenue growth, TTM	52.9%	83.3%	2%
A/R growth, TTM	14.1%	337.2%	12.4%
Inventory growth, TTM	42.4%	7.3%	22.1%
Revenue growth, year ago	15%	(14.3%)	(11%)
A/R growth, year ago	(6.7%)	(57.9%)	(21.5%)
Inventory growth, year ago	(1.6%)	(31.8%)	(16.4%)
Revenue growth, 2 years ago	25.2%	(2.8%)	4.4%
A/R growth, 2 years ago	38.5%	17.2%	7.4%
Inventory growth, 2 years ago	12.8%	9.9%	14.3%

Source: Capital IQ, a division of Standard & Poor's; TTM = trailing 12 months.

As you can see, over the past couple of years, Cree has done a pretty good job of keeping inventory and A/R growth in line with revenue growth (I'm not particularly worried about the decline in both relative to revenue a year ago). Veeco really let A/R growth get out of hand and the size of the growth means investors should really take a close look. Philips is running A/R and inventory growth faster over the past year and had a bit of a disconnect on inventory growth a couple of years ago. Investors should keep a weather eye out.

Pay attention to the balance sheet, plug a few numbers into a simple spreadsheet, and, according to O'Glove, you can get ahead of Wall Street. This easy analysis, along with a bit of thought as to what could be happening, gives you the potential to save yourself the heartache of seeing your investment get sharply cut when a company reports a "surprisingly" disappointing quarter.

The warning signs are often there ahead of time. This tool helps you see them.

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