[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.
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.