Investigating Inventory

Keeping an eye on inventory levels can keep more than a few dollars in your pocket. One researcher, in fact, claims careful inventory analysis can help investors avoid the majority of tech flameouts.

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By Rex Moore (TMF Orangeblood)
July 8, 2002

If you're like most investors, you've seen the value of some of your stocks take a turn for the worse over the past couple of years. That's certainly the case for me as well. Hopefully, we can examine some of these situations and learn exactly what went wrong, with the goal of avoiding the same mistakes in the future.

Regular readers of this website are no doubt aware that inventory is an important component to watch. An increase in inventory levels relative to revenue is a red flag that demands a closer look. In fact, when examined in conjunction with accounts receivable, inventory can be one of the most reliable predictors of the future direction of a company. Today we'll look at inventory on its most basic level, and next week we'll do some fine-tuning and break down this balance sheet item into its different components.

One of the early pioneers in the art of inventory analysis is a name I've brought up before: Thornton O'glove. In his book Quality of Earnings, he tells the story of one Bernard Smith, who made big money shorting stocks in the early 1930s. One day "Sell 'Em Ben" decided to visit a manufacturing company that was defying Depression-era odds and setting new highs on a regular basis. Because of his reputation, though, management refused to see him. So, Smith ambled around to the back of the plant and saw that, of the company's five smokestacks, only one was actually producing smoke. Taking this as a sign that production had been cut back severely, Smith shorted the company -- and cashed in when its share price crumbled several weeks later.

Luckily, these days we don't have to risk trespassing charges in order to gauge a company's business condition before it tells us (and everyone else) with an earnings warning. Inventory and receivables figures, monitored on a quarterly basis, "could have predicted the collapses in the price of perhaps four out of every five stocks, which occurred during the high-tech washout in 1984-1985," according to O'glove.

That's a powerful statement, and one that begs to be tested against our own high-tech washout over the past couple of years. I'll pick two companies that were widely held before the recent tech collapse, Lucent and Cisco, and see if their inventory levels could have warned us ahead of time.

In 1996, AT&T (NYSE: T) spun off telecom and networking equipment maker Lucent Technologies (NYSE: LU). In the next three years, Lucent's value ran up a staggering 950%. The stock then collapsed even more suddenly, skidding from $82 to its current price below $2.

Here's a look at quarter-by-quarter revenue and inventory levels from Sept. 1998 through June 1999:

  Quarter ended        % change
  (in millions)    (from prior year)
  -------------    -----------------
  Sep 98
Revenue    8,038         16%
Inventory  3,081          5%

  Dec 98
Revenue    9,204          6%
Inventory  3,778         45%

  Mar 99
Revenue    8,220         34%
Inventory  4,332         51%

  Jun 99
Revenue    9,315         29%
Inventory  5,179         74%

For the quarter ended Sept. 1998, Lucent's revenue increased 16% from the same quarter the year before, while inventory rose only 5%. The following period, revenue was up just 6%, while inventory skyrocketed 45%. Thus began a string of five consecutive quarters where inventory increased faster than sales. The Dec. '98 results should have served as a red flag. That in and of itself was not enough to sell; perhaps the extra inventory was needed to meet demand. By the next quarter, though, most investors who placed great store in inventory analysis had their fingers on the sell button, and by the following quarter -- when sales rose 29% and inventory 74% -- they were gone.

Lucent's price continued to rise for two more quarters, even as inventory continued to outpace sales. On Jan. 6, 2000, the company issued an earnings warning, and the game was up. The share price has continued to slide to this day, and nothing on the inventory line of the balance sheet has been very encouraging throughout the freefall. In the most recent two quarters, revenue has fallen off about 40%, while inventory has dropped 60%, so maybe that particular situation is starting to right itself.

One of Lucent's chief competitors at the time was Cisco Systems (Nasdaq: CSCO). It should be interesting to check out its inventory numbers because, even after Lucent had toppled, Cisco was considered an efficient company with a good balance sheet. Could a close eye on inventory foretell Cisco's fall as its customers' capital spending nearly trickled to a halt?

  Quarter ended        % change
  (in millions)    (from prior year)
  -------------    -----------------
  Mar 00
Revenue    4,919         56%
Inventory    878         41%

  Jun 00
Revenue    5,745         60%
Inventory  1,232         89%

  Sep 00
Revenue    6,519         68%
Inventory  1,956        199%

  Dec 00
Revenue    6,748         55%
Inventory  2,533        264%

This situation was tougher to gauge than Lucent's. The quarter ended June 2000 saw the first sign of trouble, with inventory growing 89%, compared to a 60% increase in sales. By that time, the stock price was off its all-time high of $80, though still pushing the $70 mark. Jittery shareholders had an excuse to bail out by the next quarter, however, when inventory jumped almost 200%, compared to sales growth of 68%. Even those who waited one more quarter -- while still burned compared to the stock's highs -- could have avoided further losses of 50% or more.

There is certainly much more to evaluating companies than just considering inventory levels. But there's no doubt they are a good predictor of future troubles, and simply avoiding companies that are growing inventory faster than sales could have saved investors a good deal of pain in the past few years.

There are different components of inventory, however, and learning about them can give us an even greater predictor than inventory as a whole. Next Monday, I'll take a look at how raw materials, work-in-process, and finished goods relate to one another... and how they can tell us if a company is heading for a slowdown.

Rex Moore will write for food -- preferably donuts. At press time (and Eastern daylight time) he owned no companies mentioned in this article. His holdings, and the Fool's disclosure policy, are available on that Internet thingie.