Here's some stark reality for you: 70% of new product introductions, 70% of acquisitions, 80% of joint ventures, and more than 90% of startups fail to create lasting shareholder value. So says Bain & Co. consultant Chris Zook in his forthcoming book, Beyond the Core.
How does an investor pick the best companies when the statistics favor failure?
It's about finding the best people who make those choices, and that's management. Last week I offered a few Management Rules for a first qualitative look. This week we move to financial indicators of management skill and an easy-to-apply ratio.
Any serious investor will tell you that successful executives are "good capital allocators." When you strip away all the management-speak, the biz-book marketing, and the financial media CEO hagiographies, it's about one thing: How well does management decide whether this dollar goes here, there, or anywhere? Whether to fund this research and development project, build that factory, buy that company, pay down debt, keep cash in the bank, buy back company shares, or issue a dividend?
A simple measure
For our purposes today, let's say we grant management the benefit of the doubt: It is deploying the cash for the highest return on investment. The CEO of a drug maker determines that this drug candidate should get the development cash, and that one should not. A semiconductor CEO decides that it will invest in this line of Wi-Fi chips rather than that one. How do these folks handle the cash that accrues from the choices they make?
One way is to look at working capital management. Alone, it's not a reason to buy or sell a stock, but it can be in concert with other factors. Here's one measure of working capital management along with five companies that score poorly on it, and five companies that score very well.
Go with the Flow
Working capital is what it says -- it's the money the business "works" with. The visionaries may be figuring out how to build a better light bulb to storm the market in five years or a better drug to save the world in 15 years, but meanwhile there are short-term considerations management must consider: inventories to be managed, accounts receivable to be collected, suppliers to be paid, and near-term debts to be repaid. Execs must manage all of these to keep operations going and creditors happy.
One of our favorite measures of working capital management is the Flow Ratio -- a staple of the Rule Maker investing strategy. The formula is this:
(Current Assets - Cash*)
Flow Ratio = --------------------------------
(Current Liabilities - ST Debt**)
* Cash = cash & equivalents, marketable securities, and short-term investments
** Short-term debt = notes payable and current portion of long-term debt
The Flow Ratio turns some financial thinking on its head. It takes two elements of working capital -- inventory and accounts receivable -- which are usually thought of assets, and treats them as liabilities. It then takes accounts payable, considered to be liabilities, and treats them as assets. This is the thinking: It's good if you don't tie up cash in inventory and receivables and good that you can pay suppliers later, keeping your cash longer.
Rising bad, declining good
High Flow Ratios are bad and low Flow Ratios are good, but more important is the trend. A rising Flow Ratio (bad) means that inventory and accounts receivable are tying up more company assets and that the company is paying suppliers perhaps too quickly. (Are they demanding quicker payment for fear it may not come?) A declining Flow Ratio (good) means that the company is investing less in inventory and accounts receivable -- perhaps managing them both better -- and paying suppliers later.
Because changes in working capital appear on the cash flow statement, a rising Flow Ratio takes away net cash from operations and reduces free cash flow (FCF), and a declining Flow Ratio increases net cash from operations and free cash flow.
Five poor Flow Ratio trends
To find examples of businesses with poor working capital management, I screened all companies traded on the New York Stock Exchange, the American Stock Exchange, and the Nasdaq for those with most-recent-quarter Flow Ratios of 3.0 or higher and increases every quarter sequentially over the past five quarters. The worst five are Orthodontic Centers of America
|WORSENING FLOW RATIO|
|Plastics||Testing and Assembly
|Q1 (most recent)||7.08||6.61||6.04||3.51||3.51|
Because these trends of inventory and accounts receivable relative to payables indicate trouble, the five are excellent candidates to research for possible shorts. At the very least, current shareholders should ask whether it's time to sell. Are there other indicators?
Four quarters of plummeting year-over-year sales alone could be enough to jettison Newport and Orthodontic Centers, but the latter is more vulnerable. Orthodontic Centers sags under debt that's 10 times greater than cash and equivalents. Newport can ride out a very long storm with no real debt, $264 million in cash ($6.80 a share), and little cash burn.
The reverse sales story greets Qiao Xing, Able Labs and A. Schulman, where year-over-year revenues have grown each of the last four quarters. But bad signs for A. Schulman are that, with one small exception, gross margins have declined sequentially for six quarters and the company turned cash flow negative two quarters ago.
Able Labs cheated death with a June private placement that it used in part to pay down debt, but it all depends on what happens to its cash burn -- which until the most recent quarter exceeded its current cash on an annualized basis. We also don't know how much cash it has today, because it hasn't disclosed the price of its purchase last week of a generic liquid drug maker's assets. Finally, its cash conversion cycle has worsened for five quarters, and moved from 112 days to 166 days in the last four. This isn't a high number for a drug maker but is a very bad trend.
Finally, Qiao Xing is a Chinese telecom equipment maker with total debt twice that of cash and equivalents, declining gross margins, and negative free cash flow in the most recent quarter. Don't phone home.
5 excellent Flow Ratio trends
Now to the bright side. Next I screened for Flow Ratios that improved sequentially over the last seven consecutive quarters. This will filter out a lot of companies: ones that have a bad quarter (as do most real-world businesses) but still show great improvement, and ones whose businesses and therefore Flow Ratios vary seasonally. But we still find five -- only five of the 8,000 publicly traded companies in the U.S. -- that satisfy this screen: ATA Holdings
|IMPROVING FLOW RATIO|
|Q1 (most recent)||0.59||0.86||0.95||1.79||1.94|
Anything else good here besides squeezing the working capital?
Like most airlines, ATA Holdings, owner of ATA Airlines (formerly American Trans Air), has plenty o' debt -- here over two times cash. But on the plus side it sports three quarters of increasing gross margins and free cash flow (the latter boosted by improved cash management), and four consecutive quarters of double-digit year-over-year revenue growth. Personally, I've never had any interest in airlines or picking the cycle of any so-called cyclical industries except semiconductors. If you do, ATA merits your attention.
Exar has four quarters of declining year-over-year revenue but is cutting its cost of goods sold faster: By definition this yields four quarters of increasing gross margins. The company is debt-free, brags $10.56 a share in cash, and has at least eight quarters (I only went back that far) of free cash flow. But the market has priced the stock for this improvement. It's selling at an enterprise value (EV) that's 25 times trailing-12-months FCF, and for a company with declining sales I think that, like Kansas City, it's gone about as fer as it can go.
Unlike Exar, Harris has four quarters of 12% to 24% year-over-year sales growth to provide good cash news on top of a declining Flow Ratio. But with gross margins down and debt the same as cash, an EV/FCF ratio of 18 suggests to me there's not enough opportunity here to push me to further research.
U.S. Xpress? Nothing recommends further research. Three quarters of negative free cash flow. Little cash and $150 million in long-term debt -- though if you count receivables, the picture isn't as bad. Nothing to get past the first stage into more detailed work.
The best for last: With Storage Tech's sales growth only 4%, 5%, 7%, and 4% in the last four quarters and its market not currently booming, this isn't a high-growth story. Not only that, management's cash skills may have reached the limit of the rewards it can generate. But the company today has $8.16 in cash per share, minuscule debt, and sells for an EV/FCF ratio of 5.9. I think the stock is a prime research candidate for a possible value investment.
One last caveat: With the stock prices up, management at these companies have been selling shares and making money. None sports what would be a great positive -- a pattern of heavy insider buying.
Time to beat the drum for our annual stock-picking guide, Stocks 2004. Our 39% return for the 11 selections in Stocks 2003 handily beat the S&P 500's 17% -- and we have worked our hardest again to bring you 11 intriguing ideas for the year ahead. This year, join your favorite Fool analysts Bill Mann, Zeke Ashton, Matt Richey, Rex Moore, LouAnn Lofton, Rick Munarriz, Paul Elliot, and, let me see... who am I leaving out? Oh yeah, Tom Gardner, too. Other Tom.
Will we do as well as last year? I'm hoping to best my two selections, Ligand Pharmaceuticals
Stocks 2004 is great analysis and intriguing stock picking. I hope you enjoy it.
Have a most Foolish week, and thanks for reading!
Senior Analyst Tom Jacobs owns no shares of these companies, but he will be on the beach in Puerto Rico next week. To see his stock holdings, view hisprofile, and check out The Motley Fool'sdisclosure policy.