Let's Pop the Hood at Oshkosh

I'm going to let you in on a little secret today: I'm a Fool.

Many of my dearest friends would readily quip, "We knew that already," so let me explain. I subscribe to the Foolish philosophy of buying in thirds. Find an interesting company, attractively priced. Buy a small position (getting some skin in the game is a great way to focus one's attention), and then take a closer look before buying more. Well, a few weeks back, I bought my first "third" in truck- and construction equipment-maker Oshkosh (NYSE: OSK). Now it's time to ...

Kick the tires
My first glance at Oshkosh's earnings make me want to double down on my investment. The company reported 7% sales growth -- no mean feat in today's tough residential construction market -- and posted a 9.5% operating margin, better than rival Federal Signal (NYSE: FSS) managed but worse than Terex (NYSE: TEX) did. These results caused earnings to jump 43% to $0.97 per share. Management even maintained its previous guidance of 19% earnings growth to around $4.25 a share this year.

Sound good so far? That's what I thought, too, until I realized that all of the above was just the GAAP version of Oshkosh's story. The free cash flow version set off the alarm bells for me. Turning to Oshkosh's cash flow statement, we see that FCF vaporized in Q2. Whereas Oshkosh generated in excess of $200 million in free cash flow in the fiscal first half of 2007, the company has burned through $18 million so far this year.

How?
Good question, and unfortunately, Oshkosh's laconic cash-flow statement doesn't provide a lot of detail. We get just two line items to describe how nearly $110 million in net profit translated into less than $27 million in cash. To learn the answer, I popped the hood on Oshkosh's balance sheet and compared the numbers there to what Oshkosh reported a year ago.

What I found was that with sales up just 7%, inventories grew 12%, and the fastest-growing subset of inventories was "finished goods" -- trucks built but sitting around, tying up cash, unsold. Those jumped 32% year over year.

Foolish takeaway
Cheap as Oshkosh's stock looks, the inventory picture worries me mightily. It suggests that the slowing U.S. economy is starting to weigh on Oshkosh. (Why it didn't hurt Spartan Motors (Nasdaq: SPAR) last week eludes me.) For the time being, international customers, and the free-spending feds, are picking up some of the slack for Oshkosh -- but if I don't see inventories drop back to reasonable growth rates PDQ, I'm going to have to postpone buying my second "third" indefinitely.