FOOL PLATE SPECIAL
An Investment Opinion
by Louis Corrigan
Safeskin Skinned by Downgrade
After losing nearly $3 yesterday following an apparently strong Q3 earnings report, Safeskin (Nasdaq: SFSK), a leading manufacturer of powder-free, disposable synthetic gloves for hospitals and other medical personnel, was skinned for a $5 3/8 loss to $19 3/8 this morning, leaving this one-time highflyer feeling like a wad of used latex. Today's plunge came after Solomon Smith Barney analyst Melissa Wilmoth cut her rating from "buy-high risk" to "neutral-high risk" and lowered her FY99 EPS target to $1.22 from $1.29. Of paramount concern was the third quarter surge in accounts receivable and inventories, which appeared worrisome in light of continued evidence of higher-than-expected inventories at distributors. "These concurrent trends are a classic sign of potential trouble," noted Wilmouth in a research update.
In the third quarter, sales jumped 31% to $61.6 million while net income soared 40% to $16.2 million or $0.27 a share, which was two cents ahead of estimates. Adjusting for currency changes, net income was up a stunning 58%. Gross margins rose to 52%, a long-term target area, from 44% a year ago thanks to higher average selling prices of newer synthetic gloves and lower costs owing to a continued shift in production to a new facility in Thailand. Thanks to some leveraging of the balance sheet, the firm's already terrific return on equity rose to nearly 80% annualized. Net income, however, benefited from a lower tax rate, which dropped to just 2% from 10% due to net operating loss carryforwards (NOLs) that will keep the rate at 2% for the next 3-5 years. After that, the rate will return to the 10% to 11% range thanks to tax holidays at its overseas plants.
Amidst all this good news, though, receivables rose 90% year-over-year while inventories increased 57%. Sales nudged ahead just 5% from the $58.6 million reported in Q2, while receivables shot up 61% and inventories increased by 11%. Such soaring receivables often indicate that a company is pushing customers to take orders so it can make its quarter. Add rising inventories into the picture, and it begins to look like demand for a company's products is slowing. While there's been some mild interest in Safeskin by short-sellers, the latest balance sheet certainly could attract more skeptics.
However, in the conference call (transcript posted by CBS.Marketwatch), Safeskin's management offered some plausible explanations. Chair/CEO Richard Jaffe explained that capacity constraints had kept inventories unacceptably low in Q4 1997 and Q1 1998, forcing customer allocation. With added manufacturing capacity, the company has boosted inventories in order to do better at filling orders. Also, the company has aimed to keep inventories high during the transition from its Malaysian facility just to be sure there's not a shortfall. At the same time, new capacity has allowed Safeskin to give a "green light" to its sales force, which produced a great deal of new orders at the end of the quarter. Since the quarter ended, receivables have been reduced to $30 million, and CFO David Morash said, "I do not expect that receivables will be higher than the Q3 level at the end of the year." Days sales outstanding stood at about 110 at the end of Q3 (up from 80 in earlier periods) and could run around 100 days for just "a couple of quarters," Morash said. Investors might want to take a closer look at this very high return on capital business to see whether management or Wall Street is telling a more persuasive story.
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