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Converting profits into cash

After making several trips to Home Depot for various home-maintenance supplies, Bill Mann wondered how the company possibly keeps all that inventory on its books. So Bill used one of the old standbys in securities analysis, the cash conversion cycle. He learned Home Depot turns over its inventory every 66 days.

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By Bill Mann (TMF Otter)
August 28, 2002

[Editor's Note: This column was corrected from an earlier version that contained a calculation error in regard to the Days Inventory Outstanding numbers for each profiled company.]

I had two inspirations for this column. The first was home repair or, more specifically, my attempts to repair my home. The second is my interest in Home Depot (NYSE: HD) for the Rule Maker Portfolio.

In the last three weeks, I've finally started those maintenance jobs I put off around the house. I had a bunch of little things to take care of: a towel rack that keeps coming off the wall, some azaleas that threatened to take over my back yard, a front door that was looking a bit weather-beaten -- that kind of thing. As a result, I made the trek to Home Depot to pick up some supplies. Of course, I forgot some stuff; so in the past three weeks, I have made five, count 'em, five trips back to Home Depot. And the place had everything I needed.

This got me thinking. Those stores are awfully big -- Home Depot's inventory needs must be massive.

I had an interesting conversation with a participant in our ongoing When to Sell seminar. He wrote about another big-box store -- arts-supply giant Michaels (NYSE: MIK). His analysis of the company was spot-on -- excellent inventory control, good economics, strong growth, and some nice observations about internal operations. It's a similar company to Home Depot in that it has a huge number of products, some of which sit on the shelves for years. Those are generally goods the company has paid for but gets no return on.

Because I've been considering Home Depot for the Rule Maker Portfolio, questions about its ability to turn over inventory are germane. I don't think we've talked about this for a while so, in the spirit of Back-to-Basics Week here at The Motley Fool, let's take a look at two nifty tools for investors: the cash conversion cycle and the inventory turn.

Although it would take some grade-A imbecility to get there, it's entirely possible under the accrual system in accounting for a company to go bankrupt while showing operating profits. Why? Because you can't pay your vendors with "profits"; you must pay them with cash. A company that does a poor job of bringing in cash, even if it's selling lots of stuff, should be avoided.  Let's break this down by components.

1. Days inventories outstanding
The coolest thing about this particular component is its acronym: DIO. What we want to know is the number of days it takes for a company to "turn" its inventory. I'm going to use the 2001 annual results both for Home Depot and Michaels.

                     Home Depot     Michaels
Cost of Goods Sold       37,406        1,660
COGS per day                102          4.5
   (annual COGS/365)
Inventories               6,725          714      
DIO                          66          158

See how that works? Let's do the same thing with the other two components.

2. Days sales outstanding (DSO) is the amount of time it takes the company, on average, to receive money after it has sold a good or service.

                      Home Depot     Michaels
Revenues                  53,553        2,530
Revenues per day             146            7
    (annual revs/365)
Receivables                  920           21
DSO                            6            3

3. Finally, we have to subtract back from this total the number of days the companies hold onto cash after they pay for something. So we must also know the days payables outstanding (DPO).

                     Home Depot      Michaels
Cost of goods sold       37,406         1,660
COGS per day                102           4.5
(annual cogs/365)
Accounts payable          3,436           351
DPO                          33            78

Now, to finish and come up with the cash conversion cycle, you simply add the three numbers for DIO, DSO, and DPO. Be careful, though. DPO is a negative number.

Home Depot's cash conversion cycle: 66 + 6 + (-33) = 39 days

Michaels' cash conversion cycle: 158 + 3 + (-78) = 83 days

So, even with all that inventory, Home Depot is still able to convert its own expenditures back into cash in only 39 days. That's astounding. Michaels comes in at a much higher 83 days, though its inventory requirements are significantly higher than Home Depot's as a function of revenue. You can do these numbers on a quarterly basis (taking care to divide by 90 instead of 365) to have a more sensitive tool for determining the trend toward faster or slower cash conversion.

A historic example
When Matt Richey, Tom Gardner, and I warned about Lucent (NYSE: LU) back in early 2000, the ever-lengthening cash conversion cycle tipped us off that Lucent was slipping quickly. As it turns out, this trend only accelerated. And as a result of Lucent's poor management decisions, the company has lost more than $200 billion in market capitalization, and followed several years of consistently "improving" financials and profits with a three-year string of grievous losses. Some of this is because the market for Lucent's products went to hell in a handbasket (where did that term come from, anyway?). But I wrote "improving" to show that in some ways, for two years before the company's collapse, Lucent's financials were not improving at all.

Lucent Technologies (all numbers in millions of dollars)
                        1999       1998       1997
Revenues              38,303     31,806     27,611
Cost of goods sold    19,688     16,715     15,318
Inventories            5,048      3,279      2,926
Receivables           10,438      7,405      5,373
Payables               2,878      2,157      1,931

Nice top line growth, eh? This was a big company growing bigger. Costs of goods sold are also pretty flat. Net margins aren't really changing, which, for a company of this scale, is to be expected. So, using our formula for the cash conversion cycle of DIO + DSO - DPO = CCC, we get the following trend:

                        1999       1998       1997
DIO                       93         71         69
DSO                       98         88         71
DPO                       53         46         45
CCC                      138        113         75

So in a matter of two years, Lucent was collecting money on its sales an average of 63 days slower. That's a problem, and as it turned out, one that portended much larger issues for the company.

Cash conversion cycles don't translate well from industry to industry, so comparing companies that don't directly compete may not be helpful. Still, I'd watch these cycles closely on a company-to-company basis, as they might warn of weakening business fundamentals that don't show up elsewhere.

Fool on!

Bill Mann, TMFOtter on the Fool Discussion Boards

By the way, if someone knows how to smooth out a coat of urethane on wood, Bill would be most appreciative. He owns none of the companies discussed in this article, but he wouldn't turn away an honorarium from Home Depot, in consideration of his contributions to its top line. Please consult The Motley Fool's disclosure policy.

The Rule Maker Portfolio sold 147 shares of Intel on Aug. 22 at $19.01 per share.

The Rule Maker Portfolio has had a cumulative investment of $42,000. As of Aug. 27, 2002, its current value of all cash and equities is $27,523.07. This equals an internal rate of return of -13.9% since the launch of the portfolio in February 1998.


 

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  Ticker Company Price
 Change
 Daily Price
 % Change
 Price 
  NOK NOKIA (0.52) (3.72%) 13.45 
  AXP AMERICAN EXPRESS COMPANY (0.85) (2.29%) 36.24 
  SGP SCHERING-PLOUGH CORPORATION 0.10 0.44% 23.05 
  COST COSTCO WHSL CORP NEW 0.49 1.50% 33.21 
  PFE PFIZER INC (0.13) (0.39%) 33.11 
  TROW PRICE T ROWE GROUP INC (0.96) (3.33%) 27.90 
  KO THE COCA-COLA COMPANY (1.24) (2.36%) 51.28 
  JNJ JOHNSON & JOHNSON (0.39) (0.71%) 54.36 
      
  Trade Date # Shares Ticker Cost/Share Price  Total % Ret  
 02/15/00 250 NOK 27.21 13.45  -50.57%
 05/26/98 95 AXP 35.38 36.24  2.68%
 08/21/98 44 SGP 47.99 23.05  -51.79%
 07/29/02 41 COST 35.89 33.21  -7.47%
 02/03/98 66 PFE 27.43 33.11  21.23%
 02/03/98 75 TROW 34.12 27.90  -17.97%
 02/27/98 27 KO 69.11 51.28  -25.48%
 04/03/01 30 JNJ 47.28 54.36  14.97%
      
  Trade Date # Shares Ticker Total Cost Current Value  Total Gain  
 02/15/00 250 NOK 6,802.85 3,362.50  -3,440.35 
 05/26/98 95 AXP 3,360.87 3,442.80  81.93 
 08/21/98 44 SGP 2,111.70 1,014.20  -1,097.50 
 07/29/02 41 COST 1,471.49 1,361.61  -109.88 
 02/03/98 66 PFE 1,810.57 2,185.26  374.69 
 02/03/98 75 TROW 2,559.06 2,092.50  -466.56 
 02/27/98 27 KO 1,865.89 1,384.56  -481.33 
 04/03/01 30 JNJ 1,418.50 1,630.80  212.30 
Cash:7,131.86 
Total:23,606.09 


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Notes
The Rule Maker Portfolio began with $20,000 on February 2, 1998, and it added $2,000 in August 1998 and February 1999. Beginning in July 1999, $500 in cash (which is soon invested in stocks) is added every month.