Don't Let It Happen, Brocade Communications

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.

Similarly 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.

Note, I'm not talking about normal business cycle stuff. Many retailers build up inventory prior to the holiday season in order 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 a potential sign of a risky investment and makes me dig a bit deeper to see what's going on.

So let's apply this to Brocade Communications Systems (Nasdaq: BRCD), a networking and storage player. Here's what the company has reported for the last four quarter period, and for the last two year-over-year periods. I've also included a couple of others for comparison's sake.

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

As you can see, Brocade has seen some huge swings in A/R and inventory growth. That spike a year ago is quite disturbing. When paired with the large jump in A/R growth and a further jump in inventory this past year, I would not be surprised if the company has recently reported (or will report in the future) disappointing results. Cisco is also letting A/R and inventory grow faster than revenue over the past year, so bad things might be coming up from them, as well.

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.

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