How to Analyze Receivables & Inventory

February 11th, 2010 | Comments (14)

How to Perform Inventory and Receivables Anlaysis

I wanted to go through a quick exercise that I perform during a stock analysis.

A recent stock that has come up in the Graham stock screener and forum is CONN. Conn’s Inc is a specialty retailer of home appliances such as fridges, freezers, washers, dryers and consumer electronics such as TV’s, cameras, computers etc. Think Best Buy.

The company just released their results for their 2009 4th quarter results and the stock took a 17% hit. The actual financial statements hasn’t been released but I wanted to show how these things are foreseeable by analyzing the inventory and accounts receivables. This has also been discussed in the balance sheet analysis.

Sales, Inventory and Receivables Analysis

For any company that sells products, a careful look at the correlation between sales, accounts receivables and inventories is crucial. In the above example, I’ve only compared the 3rd quarter statements but you can see that CONN does not know how to manage their assets.

From what I see, the problem began to surface in 2006 where revenue only increased 0.23% while accounts receivables increased 31% and inventory went up 8%. Before 2006, the company was able to grow revenues at a faster rate than accounts receivables and inventory but from 2006 onwards, the correlation worsened until 2008 where you can immediately see that things were bound to fall apart.

In 2008, revenues declined 3% compared to the previous comparable period while accounts receivables increased by 116% and inventories up 9%.

The same thing happened in 2009 where accounts receivables increased another 102%! The only thing waiting for CONN is trouble, and it finally surfaced in their latest quarter. It goes to show that Wall Street does not perform the proper analysis required.

Here is a graphical view of the same thing.

Whenever you see either accounts receivables of inventory increase quicker than sales, watch out. But for inventory, you need to dig deeper.

When raw materials component of inventories is advancing much  more rapidly than the work-in-progress and finished goods components, this means that the company is receiving many new orders and an inventory buildup is necessary. So the company will simultaneously ship products from its finished goods inventory while ordering raw materials in larger amounts.

But in the case of CONN, the company only sells the items so 100% of inventory is finished goods so any excessive increase is a big red warning sign.

Dirt Cheap or Value Trap

All valuations point to a cheap company. Looks like the intrinsic value is roughly $15-$16.

If I had come across CONN when I first started investing, I’m pretty sure I would have bought it. At today’s price of $4.61 it is definitely cheap and tempting but until there are signs that management is able to get a handle on inventory and accounts receivables, it is best to leave it alone.

Sure the stock can go up, but it doesn’t hide the fact that the company is struggling. CONN has also increased their accounts payables and taken on huge amounts of long term debt.

If I was to buy the stock now, I would only be speculating and hoping that things improve.

CONN Stock Summary

Disclosure

None

About Jae Jun


Jae Jun is the founder of Old School Value. He is on a mission to provide practical and actionable value investing tools, tutorials and educational material to help empower the individual investor. Keep in touch with Jae via any of the methods linked below.

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  • Jason

    Nice analysis Jae

  • rupneu1

    Nice analysis. I was looking at CONN a while ago and decided not to buy for the same reasons. This is exactly what Quality of Earning book tells us. Only question I had was why do you compare only the same quarter for each year and not annual data for previous years plus the quarterly report since the last fiscal year and compare quarter to quarter?

  • Jason

    I also looked at CONN but decided not to jump in. While I don’t disagree with your analysis, I believe that some of the AR jump was due to accounting changes, where the AR used to be sold through securitization and held off-balance sheet (however, I can remember if they sold the credit risk or not). If I remember correctly, this could explain the trend you are seeing here.

  • http://www.oldschoolvalue.com Jae Jun

    @ rupneu1,
    Exactly. None of my ideas are original. All from books and other good sources of info.

    In this example, I only needed to look at the 3rd quarter comparables to know that something was wrong so I didn’t go further.

    The quarterly reports also give a better view when analyzing inventory and receivables.

    @ Jason 2,
    Thanks for the thought but even if it was an accounting change, I don’t see how it would increase AR by over 100% in 2 consecutive years. The increase in payables also tells the same story and accounting changes wouldn’t be made to that.

  • dacian

    hi

    I read your DiVX analysis; very good one. The question I have is, what’s your target sell price? thanks

  • Ziv

    Hey Jae,
    Although I’m still trying to figure everything out,
    Something is a bit weird for me at the moment.
    can’t the rise in AR be the result of two bad years? (for the economy, not particulary for the company) after all AR is just money that debtors owe the company, although the number has risen, it still means money will get to the company, just not now, right (maybe the company changed the way it credits payments)?
    I tend to take the rise in inventories differently (the company accumulated more than it can sell) and so that number means more to me.
    Am I getting anything wrong?
    Thanks a lot, to anyone that tries to help.
    Ziv.

  • http://www.oldschoolvalue.com Jae Jun

    The trouble that I am pointing out is that the rise in AR is ginormous. The company didn’t increase it by 20-30%. Over the past 2 years, it has increased by more than 100% each time. This clearly shows that the company is trying to sell to anyone or the conditions clearly put them at a disadvantage. Looking at the above numbers, I’m pretty sure that their days in receivables numbers is horrific. A company needs cash to continue business, not an IOU. If this gets out of hand, they will have to take on debt to increase their cash position, which is exactly what CONN did.

  • Emiliano

    very nice and instructive post Jae, thanks for sharing

  • http://www.oldschoolvalue.com Jae Jun

    Thanks Emiliano

  • Nick

    Hi Jae, a bit late I know, but I have a very small query for you please.

    I see that you have include a EV/FCF ratio. Why?

    The way that you calculate FCF doesn’t seem to me to be a cash flow to both equity and debt holders; if it was, surely you would have included tax-deductible interest?

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