Ignoring This Could Put Your Investment at Risk

Fellow Fools, I have a confession to make. There's a line on companies' balance sheets labeled "inventory" that I typically ignore.

I understand the importance of the number if you're investing in a retailer like Wal-Mart or Sears Holdings. Managing inventories is necessary for maximizing returns. There's only so much capital available, and companies can't have it tied up in inventory that isn't selling.

But the drugmakers that I cover at The Motley Fool sell high-margin products; investment in inventory isn't as important. As long as a drugmaker can increase revenue by a substantial amount, it doesn't really matter how much inventory it carries -- within reason, of course.

An ah-ha moment
A couple of recent events have me a little more focused on inventories, but for a reason other than return on invested capital. Genzyme's (Nasdaq: GENZ) plant closure because of a viral contamination has wreaked havoc on the company's revenue. There's plenty of demand for its drugs, but the company can't fill the orders because production has been slow to come on line. If the company had carried a larger inventory, perhaps it could have met demand while it was ramping up production.

At the other extreme, in an interview with Investor's Business Daily, Novo Nordisk's CFO noted that the company keeps nine months of the active ingredient for its insulin products on hand, to ensure that it always have the ability to produce its product. He noted that it's for the patient -- "The obligation we have to people with diabetes is that they can rely on us" -- but the real benefit is for the company. Not being able to supply its mainstay drug products because of supply constraints would be disastrous.

Speaking of potential disasters
I decided to screen for drugmakers who might be jeopardizing their future by not holding enough inventory. Here are the worst offenders:

Source: Capital IQ, a division of Standard & Poor's. LTM = last 12 months.

Abbott and Johnson & Johnson sell items other than high-margin prescription drugs, so it shouldn't be surprising to see that the companies are trying to maximize their turnover. It's probably not the end of the world if their supply of baby formula or Band-Aids gets shut down.

For comparison, the company that started my thought process, Genzyme, has an inventory turnover of 2.4 over the past four quarters. Thought of another way, the company keeps less than six months' supply on hand. It's likely less than that, because inventories include raw materials and product that is in the process of being made, in addition to the finished product stored in a warehouse somewhere.

Risk averted?
At the other end of the spectrum, some companies have nearly a full year's worth of product to supply if things go bad:

Source: Capital IQ, a division of Standard & Poor's. LTM = last 12 months.

The high inventory levels are a good sign that the companies have plenty of product to sell, but it's not a guarantee that they can avoid disaster. If a plant needs to be shut down, and the current inventory is also tainted -- as was the case for Johnson & Johnson's children's medications -- the added inventory won't help much.

One piece of the puzzle
I'm not sure inventories will ever be a make-or-break factor in investing in a drugmaker, but they're something investors should factor in when making a decision to buy. If you're going to buy a company that doesn't hold much inventory, you'll want to make sure you're being compensated for that added risk.

Matthew Argersinger thinks the risk has exceeded the reward and suggests you short this one.