FOOL ON THE HILL

The Inventory Story

Inventory breaks down into three components: raw materials, work-in-process, and finished goods. A buildup of inventory as a whole is normally a red flag, but digging a little deeper can give us a more complete picture of whether a company's business is picking up... or slowing down.

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By Rex Moore (TMF Orangeblood)
July 15, 2002

Last week, I talked about the importance of keeping a close eye on the inventory situation of companies you're following. The reason is simple: Ballooning inventory can be devastating for a business, and that fact will eventually manifest itself through a disappointing earnings announcement.

What's so bad about carrying a lot of inventory, which shows up as an asset on the balance sheet? Well, if that particular line item increases substantially more than sales, it could indicate that demand for a company's product has fallen off, and it will soon have to discount -- or even write off -- part of it. In either case, earnings will take a hit. As explained last week, proper inventory analysis can be a great early warning system. One pioneer in such analysis, Thornton O'glove, says it can predict the majority of high-tech flameouts.

Before we move along, I should clarify a couple of things. First, inventory analysis works well for most any company that makes things... especially high-tech firms in fast-changing industries. It's not relevant, however, for service-oriented and other non-manufacturing companies. Second, all of the numbers I'm using can be found in the quarterly or annual reports filed by every public company. Free Edgar is still one of the best sites to find these 10-Qs and 10-Ks.

And now, on with the show.

Inventorying inventory
There are three basic types of inventory: raw materials, work-in-process, and finished goods. The raw materials are what's needed for a company to begin making a product. For a computer manufacturer, that could mean chips, diodes, circuit boards, and many other items -- all supplied by vendors. For a grape juice company, raw materials would consist of grapes, sugar, and any other ingredients needed to make the product.

Work-in-process is material that is tied up in partially assembled products. Finished goods, obviously, is stuff that's ready to sell. (There will be no test on this, because it's too easy.)

Charting the growth or decline in these three inventory types, relative to sales, can tell us more than what total inventory change tells us. (Again, see last week's column for a refresher course.) For example, a relative increase in raw materials can actually be a good sign. Perhaps the company is stepping up production because it has a new customer, or maybe an existing buyer has increased its product order. As O'glove says, "An increase in raw materials inventories usually means business is speeding up, and this will be reflected in future revenues and profits."

On the other hand, if raw materials and work-in-process are declining while finished goods are increasing -- a situation O'glove calls "negative inventory divergence" -- watch out. This situation likely points to a slowdown in production. The company may be having trouble selling its finished products and is slowing down until the situation gets under control.

For an example, let's look at Cree (Nasdaq: CREE), a semiconductor company that makes chips that power various products such as light-emitting diodes (LEDs) and radio-frequency transistors.

                   Total           % change
 Quarter ended (in thousands) (from prior year)
 ------------- -------------- ----------------- 
   Sep 01
Revenue            43,166            15%
Total Inventory    16,922            60%
-Raw Materials      4,530            94%
-Work-in-process    7,067           108%
-Finished goods     5,325            10%

   Dec 01
Revenue            41,092            -1%
Total Inventory    18,244            37%
-Raw Materials      3,867            36%
-Work-in-process    8,190            79%
-Finished goods     7,315            24%

   Mar 02
Revenue            33,376           -37%
Total Inventory    14,812            -7%
-Raw Materials      4,029            -3%
-Work-in-process    7,844            19%
-Finished goods     8,927            74%

Here we see a company that has been struggling with inventory for several months. For each quarter listed above, total inventory has grown faster than sales. Even in the most recent quarter, when inventory growth dropped 7%, sales were down even more, falling 37%. So there we have the first red flag. The second warning is that work-in-process and finished goods grew by 19% and 74%, respectively, in the quarter... making the situation look even worse than if we just considered total inventory alone. What's more, these numbers do not include the nearly $6 million reserve Cree took against inventory, in anticipation of writing off products it doesn't think it will be able to sell.

All of this translates into the company still having quite a bit of finished goods on hand that it may have to discount, or write off entirely, in the future. And if this happens, it will hurt earnings. I currently own shares of Cree, and I'm very concerned about this situation.

Now we'll look at Analog Devices (NYSE: ADI), a company that makes a wide variety of semiconductor products, specializing in integrated circuits (ICs) used in analog and digital signal processing. You'll find its products in computers and peripherals, CD and DVD players, camcorders, cameras, cell phones, automobiles, and many other places.

                   Total           % change
 Quarter ended (in thousands) (from prior year)
 ------------- -------------- ----------------- 
   Sep 01
Revenue           423,313           -47%
Total Inventory   246,852           -26%
-Raw Materials     18,221             4%
-Work-in-process  159,463           -11%
-Finished goods    69,168           -49%

   Dec 01
Revenue           392,974           -49%
Total Inventory   241,107           -32%
-Raw Materials     16,624           -26%
-Work-in-process  171,115           -14%
-Finished goods    53,368           -61%

   Mar 02
Revenue           413,368           -31%
Total Inventory   253,151           -21%
-Raw Materials     15,077           -32%
-Work-in-process  188,059            -2%
-Finished goods    50,015           -52%

There is some cause for concern here because, once again, we see total inventory growing faster (or, in this case, declining slower) than sales in the last few quarters. However, the situation is probably not as bad as it looks at first glance. In each of these quarters, finished goods is declining faster than sales... meaning the company has less obsolete-prone inventory sitting around than it could have. It's interesting to note, however, that the majority of the company's inventory is tied up in work-in-process, which remains at almost the same level as the prior year period. That's not as dangerous as finished goods, but not as desirable as raw materials buildup.

Finally, let's look at a company with a good inventory position, Dell Computer (Nasdaq: DELL).

                   Total           % change
 Quarter ended (in millions)  (from prior year)
 ------------- -------------- ----------------- 
   Dec 01
Revenue             8,061            -7%
Total Inventory       278           -31%
-Prod. Materials      153            61%
-WIP+Finished goods   125           -59%

   Mar 02
Revenue             8,066             0%
Total Inventory       284           -19%
-Prod. Materials      157            25%
-WIP+Finished goods   127           -43%

For the last two quarters, inventory levels are dropping much more quickly than sales. What's more, Dell's raw, or "production" materials are actually building up. As O'glove said, this usually means business is speeding up, and will be reflected in a positive earnings report.

I would have looked like a genius if this column had run last Thursday, because on that day, Dell announced its second-quarter sales and earnings would come in higher than expected!

It doesn't always work out that neatly, of course. But I would advise that every shareholder in a manufacturing company examine the inventory numbers very, very closely each and every quarter. Many times, your analysis will be able to clue you in on the company's direction before the company does... and that's what investing is all about.

Rex Moore regrets to inform you that, due to circumstances beyond his control, he is no longer available for birthday parties. At press time, he owned shares of Cree. The Motley Fool has a disclosure policy.