Foolish Fundamentals: Inventory

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The simple story
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 (NASDAQ:AEOS) and tech companies that operate in the fast lane, like Intel (NASDAQ:INTC) or Apple (NASDAQ:AAPL). Remember that 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. The former type 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.

That's because 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, and 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 by freeing 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 to a rate beyond the growth in sales, 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 a potential Hidden Gem before the Street shows up with its shovels and tries jumping our claim. This is something we call "positive inventory divergence," which is a concept taken from one of our favorite books, Thornton O'glove's Quality of Earnings.

There are different kinds of inventory: raw materials, works in process, and finished goods. To take a hypothetical example, if we make ovens, like Hidden Gems' 315%-plus-returning superstock Middleby (NASDAQ:MIDD), we will have an inventory of stuff like steel and bolts (raw), 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 the kind of bloating inventory that can be a clue to future glory. If Middleby is ramping up for increased demand it sees -- but may not have reported to the Street -- it may very well be growing certain parts of its inventory at a rate faster than sales. We would expect to see these healthy bulges in the area of raw materials and works in process. To go one further, if this is a company subject to continuing increases in commodity prices, we might also cheer its decision to buy extra raw materials while the prices are still lower than what it expects to have to shell out 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 2006 and 2005.

As Middleby shows (as of the July quarter of this year), what looks like inventory growth equal to sales growth is actually a bit more complex and holds better news for investors than the "total inventory" line would reveal at first glance. Although total inventory grew by 25%, both raw materials and works in process grew much faster, while the finished goods category barely budged. This is precisely the "positive inventory divergence" pointed out by O'glove in his book.

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 at first looks like a problem may indeed be a sign of good things to come.

Looking for the latest inventory divergents and other small caps operating under the radar? A free trial of Motley Fool Hidden Gems lets you join the hunt.

Intel and Coca-Cola are both Motley Fool Inside Value recommendations. American Eagle Outfitters is a Motley Fool Stock Advisor pick.

Shruti Basavaraj, Adrian Rush, and LouAnn DiCosmo updated this article, which was originally written by Seth Jayson in August of 2005. Neither Shruti, Adrian, nor LouAnn owns shares of any company mentioned. The Motley Fool has a disclosure policy.