Don't Let This Happen, Intuitive Surgical

Many investors, especially during earnings season, seem to focus on the income statement. How much revenue was there? How much net income? Yet the balance sheet actually tells us a lot more about how the company is doing, and what it's likely to do in the not-too-distant future. Today, I'll focus on two balance sheet line items: accounts receivable (A/R) and inventories, and how they relate to sales.

In Thornton O'Glove's book Quality of Earnings, he calls the analysis of A/R and inventory growth relative to sales the "best method" to get ahead of Wall Street analysts:

One of these simple ploys -- the best method I have ever discovered to predict future downwards earnings revisions by Wall Street security analysts -- is a careful analysis of accounts receivables and inventories. Learn how to interpret these ... a larger than average accounts receivable situation, and/or a bloated inventory. When I see these, bells go off in my head.

If A/R goes up significantly faster than sales, then the company could be stuffing the channel, pulling sales in from the future. That can be done for only so long before customers cry "Enough!" and stop buying for a while. Then the company ends up missing revenue and earnings, and the stock price gets whacked.

Similarly, if inventory is rising significantly faster than sales, that could mean demand is slowing down, and a big inventory writedown might be coming. Alternately, sales could be hurt when the company uses large markdowns just to clear out inventory.

Note that I'm not talking about normal business-cycle stuff. Many retailers build up inventory prior to the holiday season in order to meet expected demand. Instead, I'm looking for a big disconnect between the growth of sales and the growth of A/R or inventory. That's a potential sign of a risky investment, and it makes me dig a bit deeper to see what's going on.

Let's apply this to Intuitive Surgical (Nasdaq: ISRG), maker of the daVinci surgical robots. Here's what the company has reported for the last four-quarter period, and for the last two year-over-year periods. I've also included a couple of others for comparison's sake.

Source: Capital IQ, a division of Standard & Poor's; TTM = trailing 12 months.

As you can see, over the past year, Intuitive Surgical has done a fair job of keeping inventory and A/R growth under control, tracking pretty closely to revenue growth. Inventory grew handily a year ago, but that's slowed down again. Considering the long lead time on ordering their robotic surgeons, which should give management time to order what's needed, the issue with inventory might be more on the disposable supply side, which could wax and wane as hospitals perform more or fewer surgeries. Hitachi and Toshiba, much more diverse companies, have managed things pretty well for the most part, though Toshiba has let A/R and inventory growth get ahead of sales growth over the past year.

Pay attention to the balance sheet, plug a few numbers into a simple spreadsheet, and according to O'Glove, you can get ahead of Wall Street. This easy analysis, along with a bit of thought about what might be happening, gives you the potential to save yourself the heartache of seeing sharp cuts in your investment after a company reports a "surprisingly" disappointing quarter.

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