Peter Eavis
A company facing a sharp decline in earnings amid a sudden dropoff in sales will normally rush to slash inventory spending as it seeks to protect profit margins and cash.
But the inventory number at electronics maker ACT Manufacturing (ACTM Quote - Cramer on ACTM - Stock Picks) was remarkably resilient in its first quarter, even though its sales are getting hit. This has led one New York-based investor to suspect that ACT is using its inventory line as a place to temporarily park expenses that should have flowed through the income statement in the first quarter. The company released its first-quarter financials on May 2. The New York hedge fund manager, who requested anonymity, has sold shares in ACT short, meaning his fund stands to gain if they decline in price. Hudson, Mass.-based ACT's chief executive, John Pino, didn't respond to phone calls seeking comment or to a faxed list of questions on the issues addressed in this piece. But A.G. Edwards analyst Tony Boase insists that ACT did a fair job of managing its inventory in the first quarter. He says suspicions that the company has been hiding costs are part of the "misinformation" that currently surrounds the stock. (Boase rates ACT maintain and A.G. Edwards hasn't done recent investment banking work for the firm.) ACT shares are up over 90% since their early April low. Monday they advanced 26 cents to $18.20.Fun With Numbers
Excluding goodwill amortization, ACT made $8.4 million, or 49 cents a share, in the first quarter, up 36% from the 36 cents earned in the year-ago period, but down significantly from the fourth quarter's 65 cents. First-quarter earnings were aided by a sharply lower tax rate: 30% compared with 39% in 2000's first quarter and 34% in the fourth quarter. Quarter-end cash on hand plunged by two-thirds, to $16 million from $48 million at the end of the fourth quarter. But cash flow from operations was positive to the tune of $4 million. ACT is facing a challenging 2001. The slowdown in IT spending has hit ACT's biggest customers, including storage giant EMC (EMC Quote - Cramer on EMC - Stock Picks), and reduced demand for its products. As a result, Thomson Financial/First Call shows analysts forecasting that per-share earnings will drop from first-quarter levels, to 30 cents in the second quarter and 34 cents in the third quarter. Against that background, the hedge fund manager thinks ACT used balance sheet maneuvers to disguise what may have been a first-quarter loss. How so? ACT's balance sheet says inventory dropped by $28.8 million in the first quarter from the end of 2000, to $372.5 million. According to Pino's comment's on ACT's earnings call, some $25 million of that decline can be attributed to inventory that was sent back to vendors. That implies normalized inventory dropped by only $4 million, or 1%. Typically, inventory changes should be echoed by roughly proportionate changes in other balance sheet items, as well as in sales figures. But, by comparison, revenue dropped by 14% in the first quarter to $445 million, from $520 million in the fourth quarter. (Revenue fell by the same amount after subtracting inventory send-back of $25 million in the first quarter and $33 million in the fourth, both of which are reported in revenue numbers.) Also important is the accounts payable comparison. This line fell $56 million, or 16%, in the first quarter from the immediately preceding period. If $25 million of that decline is attributable to the returned inventory, then normalized accounts payable actually dropped by 9%, far more than the 1% decline in inventory.'Reasonable'
Boase is unfazed. He says that when sales droop it gets tougher to work off inventory through sales. So, for ACT to post an effectively flat sequential number is a sign that the company turned in a "reasonable performance" on inventory. "They did better than some other contract manufacturers," Boase adds. However, the hedge fund manager believes that ACT did in fact reduce inventory by a lot more than $4 million, but the inventory line was bloated by other expenses in the first quarter. "If a company can only cut back inventory by 1% when sales have fallen sequentially by 14% and are expected to fall still further, it has real problems," he says. "But I doubt they have problems on the inventory front." He thinks that in reality inventory was reduced by a lot more than $4 million, and says the substantially bigger drop in accounts payable supports his view. Inventory-related expenses don't have to hit the income statement until they are included in the cost of goods sold calculation, when, of course, they then have an impact on gross margin. If the company is concealing costs, it'll have to book these costs at some time, but it may have been very keen to avoid a loss in the first quarter.Equity
Why? One explanation may be that a loss would've eaten too much out of the company's equity. Seeing that ACT's tangible equity (shareholders' equity minus goodwill) of $80 million is dwarfed by its $237 million in long-term debt, ACT may be getting close to breaking some debt covenants. In January, ACT said that J.P. Morgan Chase (JPM Quote - Cramer on JPM - Stock Picks) had arranged a $100 million senior secured term loan. ACT added in a press release that this credit "represented an addition" to an existing $250 million senior secured credit facility also arranged by J.P. Morgan. A Morgan spokeswoman declined to comment on the bank's relationship with ACT. On the subject of the Morgan loan, ACT's 2000 annual report says this:- The Credit Agreement requires the Company to meet certain financial conditions, including net worth and the ratio of total debt, senior secured debt and interest and other fixed charges, to earnings. The credit facility is secured by substantially all of the assets of the Company and certain of its subsidiaries.
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