Don't Let This Happen to You, Monsanto

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 that focus can be dangerous, because 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 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 write-down 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 Monsanto (NYSE: MON  ) , the agriculture chemical and seed company. 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.

 

Monsanto

DuPont (NYSE: DD  )

Syngenta (Nasdaq: SYT  )

Revenue growth, TTM

(12.3%)

8.6%

0.8%

A/R growth, TTM

7.2%

7.5%

(1.1%)

Inventory growth, TTM

(10.2%)

17.5%

2.5%

       

Revenue growth, year ago

11.5%

(13.6%)

1.3%

A/R growth, year ago

(7.4%)

(13.6%)

(13.8%)

Inventory growth, year ago

43.7%

(22.3%)

29.3%

       

Revenue growth, 2 years ago

27.4%

9.7%

27.1%

A/R growth, 2 years ago

(4.6%)

15.0%

21.7%

Inventory growth, 2 years ago

32.6%

12.1%

25.8%

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

As you can see, in the past couple of years, Monsanto has let inventory growth get quite a bit ahead of sales growth. Now it might not get into the same kind of trouble a tech company would, where its inventory is rapidly obsolescent, but nonetheless this is not a good situation to be in. It is especially bad when DuPont, a large competitor, has done a better job at handling inventory growth, though it has to handle what has happened over the past year. Syngenta lands somewhere in between the two, having had trouble a year ago, but getting it back under control over the past four quarters.

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.

To learn more about how we go about analyzing companies, consider taking a 30-day trial subscription of Stock Advisor, the Fool's flagship investing newsletter.

Monsanto is a Motley Fool Inside Value recommendation, and Motley Fool Options has recommended a synthetic long position on its shares. Try any of our Foolish newsletter services free for 30 days.

Fool analyst Jim Mueller has a synthetic long position on Monsanto, but doesn't have a position in any other company mentioned. He works with the Fool's Stock Advisor newsletter service. The Motley Fool is investors writing for investors.


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Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On August 30, 2010, at 1:11 PM, funfundvierzig wrote:

    Jim, Monsanto and Syngenta are both seed companies. DuPont is a chemical conglomerate with over two-thirds of its sales and inventories involving chemicals, commodity construction materials, plastics, auto paints, undsoweiter. Less than a third of DuPont's sales came from its AG & NUT "platform" last year, 2009.

    Given the vagaries of agriculture, and seasonality, isn't it somewhat difficult to compare the seed companies with a chemical firm?

    I certainly agree with you and your insightful observation that in assessing a company's condition and the performance of its management, balance sheet data is too often ignored or subordinated.

    ...funfun..

  • Report this Comment On August 30, 2010, at 10:20 PM, TMFGebinr wrote:

    Hi funfun,

    The exact percentage for DD's Ag business is 31.7% of 2009 revenue. Pretty significant. That portion is a direct competitor to Monsanto, providing crop chemicals and seeds. You're right, though, in that the inventories also include lots of other stuff related to the other 68% of their business. DuPont doesn't break inventory out by business segment, unfortunately, so we can't say for certain how much is due to the Ag portion and how much is due to the rest. That gives it slightly different dynamics, as you noted. Given that, though, I don't think the comparison is wholly unreasonable.

    Thanks for reading.

    Jim

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