Foolish Fundamentals: Inventory

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Here at the Fool, we've long cautioned investors to keep a close eye on inventory levels. We think a quarterly checkup is key to spotting potential problems, especially with seasonally dependent, fashion-oriented retailers like Coach  (NYSE:COH) or American Eagle Outfitters (NYSE:AEO), or tech companies that operate in the fast lane, like Intel (NASDAQ:INTC) or Apple (NASDAQ:AAPL).

Remember, service businesses or companies that sell the same thing all the time, like Coca-Cola (NYSE:KO) or Cemex (NYSE:CX), may not be as inventory-sensitive as other manufacturers and retailers. But companies more tied to trends and seasons share a big potential problem: Goods that sit on the shelf for a few extra months are as good as garbage. This can be especially troublesome for small-cap companies -- the type we specialize in at Motley Fool Hidden Gems.

Too often, the only way to get rid of stale merchandise is to put it on sale, thus hurting profitability. In extreme cases, companies may even need to write off those purses and chips entirely. That involves taking a near-complete hit on the goods and -- rumor has it -- sending them out to be ground up into meat sauce for crooked school-lunch programs.

Basic guidelines
To keep a handle on inventories, we often use a simple rule of thumb: Measured across comparable quarters (year over year), inventory increases ought to roughly parallel revenue increases. Simply put, if inventories grow 35%, we hope that sales will have grown that much as well. Of course, if a company can reduce its inventory growth relative to its sales growth, that might be preferable, since it frees up money that's essentially sitting around fallow on the shelves. Hey, even bank interest is better than no return at all.

Conversely, if inventory bloats more quickly than sales grow, we expect a darn good explanation.

Exception to the rule
Fools should be aware that there's one type of inventory bulge we actually like to see. In fact, it can be a key to identifying potential Hidden Gems before the Street shows up with its shovels and tries to jump our claim. We call it "positive inventory divergence," a concept taken from one of our favorite books, Thornton O'glove's Quality of Earnings.

There are three different kinds of inventory: raw materials, works in process, and finished goods. To take a hypothetical example, if we make ovens, like Hidden Gems' 679%-plus-returning superstock Middleby (NASDAQ:MIDD), we'll have an inventory of stuff like steel and bolts (raw materials), ovens with no doors attached (works in process), and maybe even ovens (finished goods). You won't usually find inventory broken down with this kind of detail in earnings releases, but it should appear in the 10-Qs that you can get from the Securities and Exchange Commission.

Here's where rising inventories can be a good thing. If Middleby is ramping up for increased demand it foresees -- but may not have reported to the Street -- it may be growing its raw-material inventory faster than its sales. And if the company's subject to continuing increases in commodity prices, we might even cheer its decision to buy extra raw materials, since the prices it gets now should be lower than those it would otherwise pay in the future.

If, on the other hand, the bloat comes in finished goods, this might be a sign that expected sales haven't materialized, and management has some 'splaining to do.

Here's Middleby's inventory story as of the July quarter of 2007 and 2006.

As Middleby shows (as of the July quarter of this year), what looks like worrisome inventory growth is actually a bit more complex, and it holds better news for investors than the "total inventory" line would reveal at first glance. Although total inventory grew by 34%, raw materials grew much faster at 84%, while the finished goods category grew far more slowly.

See the future
When you're scanning your quarterly earnings reports, remember that many of the numbers mask situations that are more complex than they appear. When in doubt, listen to the conference call, give investor relations a jingle yourself, and make sure to check back when the quarterly report is filed. What initially looks like a problem may indeed be a sign of good things to come.