Wall Street is an inscrutable beast. Regardless of what the pretty talking heads on CNBC tell you, it's not always obvious why the Street does what it does. Or what numbers the Street will choose to focus on in a given company's earnings report on any given day. (My theory: Analysts focus on GAAP profits Tuesday and Thursday, pro forma profits on Monday, Wednesday, and Friday, and stock dilution on the sixth Sunday of the month.)
Unfortunately for investors in Motley Fool Hidden Gems pick Marine Products
Marine Products reported Q1 sales that were up 17% over the year-ago quarter. Profits rose even faster, to $0.17 per diluted share -- a 21% year-on-year increase. But none of that impressed investors. So let's examine what red flags they might have fixated on.
First up, we see that inventories rose dramatically over the past year. The company had $19.7 million worth of inventory at the end of Q1 2004, a number that increased 26% a quarter later and then held more or less steady until the quarter just ended, when it jumped another 13%. Taken separately, the sequential increases perhaps don't seem alarming. But when they're viewed from a "last time this year" vs. "this time this year" perspective, investors might be questioning why a 17% sales increase has been accompanied by a 48% jump in inventories. Just because management pronounced itself "comfortable with these levels" of inventory, that doesn't necessarily mean that shareholders felt the same way.
Next, there's the issue of free cash flow deceleration. In Q1 2004, the company generated $9.5 million in cash, while this year it generated just $6.3 million. That's not just one-third less than last year; it's also less than the company's reported GAAP profits -- an oft-cited warning sign of a company that may be massaging its numbers to look more profitable than it really is.
Mind you -- I don't think that's happening at Marine Products. Over the past year, its free cash flow significantly exceeded its GAAP profits ($26.6 million FCF vs. $23.7 million GAAP profits). More likely, the short-term reversal in that pattern is just that: short-term and something that will re-reverse itself in time. But for investors looking to take some profits off the table anyway -- Marine Products had already gained 33% since being recommended in Hidden Gems -- they may well have latched on to the cash flow slowdown as another reason to jump ship.
Fool contributor Rich Smith has no position in any of the companies mentioned in this article.