Wednesday, March 17, 1999
FOOL ON THE HILL
An Investment Opinion
by Louis Corrigan
Safeskin's Lessons: Being Safe Not Sorry
Last week's earnings warning from Safeskin (Nasdaq: SFSK), a
leading maker of high-quality disposable latex and synthetic medical
examination gloves, was a long time coming. The stock had already
drifted from $47 1/8 in July to Thursday's close of $18. Still, it was
skinned for another 50% loss on Friday and now trades for just $8
3/4. Only a month ago, the company reported its tenth consecutive
year of 25% or better growth in revenue, and Chair/CEO Richard
Jaffe projected a record FY99. So it's hard to say that one should
have avoided -- or even profited from -- the recent massacre. Still,
some did, and it's worth highlighting why.
First, a quick review of what's made the once incredibly profitable
Safeskin so unsafe looking.
On February 10, the company reported that Q4 sales rose 27% to
$63.6 million and EPS followed, up 30% to $0.27 after backing out
one-time expenses related partly to relocating a glove-making facility
from Malaysia to Thailand. For the year, revenue roared ahead 30% to
$237.1 million, pumping EPS up 43% to $1.00. Thanks to a sales mix
rich with high-margin synthetic gloves and lower manufacturing
expenses, gross margins for the quarter and the year shot up from
44% to 52%. Though juiced up by $92 million in new long-term debt,
Safeskin's return on average equity came in at a slick 52.8%.
Then came the warning late last Thursday. Due to "higher than
estimated distributor inventory levels and [a] slower-than-anticipated
ramp up of orders from new customer contracts," management now
sees first quarter sales falling a stunning $28 million below analyst
estimates. Earnings per share will slip $0.25 to $0.26 shy of the
consensus estimate, which stood at $0.27 before the announcement.
For the year, Jaffe said sales "will be lower by approximately an
additional $25 million."
At the end of the third quarter, Safeskin delivered extra product to
distributors to support an expected increase in sales. "As it turns out,"
Jaffe said, "there was more inventory in the system at that time than
we had previously estimated." Trouble is, the company's critics were
all over this problem back in October.
A Once-Friendly Analyst Dissents
We know that sell-side analysts operate under a serious conflict of
interest because they get compensated more for the investment
banking work they bring to their firms than for the investment value of
their opinions. So we place mental asterisks next to bullish comments
made by a company's underwriter and pay more attention to the
opinions of more disinterested parties. Yet, we also know that sell-side
analysts in general don't like to veer from the pack, especially by
going negative.
That's why the move on October 29 by analyst Melissa Wilmoth of
Salomon Smith Barney (SSB) merited serious attention. Wilmoth
downgraded Safeskin from "buy-high risk" to "neutral-high risk" and
cut her FY99 EPS estimate to $1.22 from $1.29. SSB took Safeskin
public. Yet here Wilmouth was worrying aloud about Safeskin stuffing
its sales channel.
When a company is having trouble making its sales number for a
quarter, it may offer resellers or customers discounts or favorable
payment terms to accept product they don't yet need, even if that
steals sales from future quarters. As Wilmoth told her clients in late
October, one large distributor had gotten very favorable terms for the
first time in a year.
Jaffe and his colleagues denied this. Yet, the wacky balance sheet
raised serious questions. Accounts receivable (what the company is
owed by customers) rose 89.7% year-over-year and 61.1%
sequentially despite just 31.3% higher year-over-year sales and just a
5% sequential revenue gain. Sales were being booked, but
distributors just weren't paying as quickly as they usually did. Rising
inventories (up 56.8% year-over-year and 11.6% sequentially) added
to the picture of channel stuffing. It was enough to make a
shareowner wonder whether the industry was slowing down or
competition heating up.
Yet, Jaffe asserted that inventories had been too low earlier and that
the transition to the new facility in Thailand caused the normal sales
cycle to be delayed somewhat, creating merely a short-term increase
in receivables. However, as Wilmoth argued in her research note,
"These concurrent trends are a classic sign of potential trouble." Boy,
was she right!
Accounts Receivable and Inventories Increase Faster Than Sales
The following table shows this enormous sequential increase in
receivables and inventory for the third quarter. Though many
businesses experience seasonal patterns that make year-over-year
comparisons more appropriate, true growth stocks often are expected
to deliver stronger sales from one quarter to the next. (Expand window
to view table.)
Sales Y/Y Seq. AR Y/Y Seq. Inv. Y/Y Seq.
Q2 58.6 30.5% 10.0% 24.9 13.0% -2.7% 31.2 47.6% 17.9%
Q3 61.6 31.3% 5.0% 40.1 89.7% 61.1% 34.8 56.8% 11.6%
Q4 63.6 27.2% 3.3% 37.7 69.7% -6.0% 35.5 67.0% 1.8%
Y/Y= year-over-year
Seq.= quarter vs. previous quarter
AR = accounts receivable
Inv.= inventories
Sales, receivables and inventories in millions
In most cases, you want receivables and inventories increasing in
lock step with sales, preferably a bit more slowly. In Q4, for example,
accounts receivable declined by 6% sequentially while inventories
rose 1.8% sequentially -- or less than sales increased. This
represented a modest improvement, but not enough to counteract or
really explain the Q3 surge.
The List of Shorts Grows Long
Month Shares Short Short Ratio
6/98 2.98 million 8.64
7/98 .21 million 6.73
8/98 3.29 million 7.65
9/98 3.57 million 7.44
10/98 3.30 million 5.97
11/98 4.16 million 1.72
12/98 4.95 million 3.50
1/99 5.08 million 5.31
2/99 6.77 million 6.05
(Short ratio = shares short divided by average daily trading volume;
also called "days to cover")
While a Safeskin shareowner should have already been concerned
by these issues, other investors (or short-sellers) might have
discovered the story by tracking monthly short interest figures. A short
ratio above 5 indicates significant short-seller interest. Safeskin made
that cut long before the Q3 earnings report led the shorts to pile on.
The numbers increased in every successive month, including a surge
following the Q4 earnings report. (The erratic short ratio numbers were
misleading since they merely reflected increased daily trading volume
as bulls and bears fought it out.)
Short-sellers can be very wrong, of course, as they have been with
many top Internet companies whose business models are only
beginning to be proven. Nonetheless, high and growing interest from
short-sellers means you should try to track down the bear take and
evaluate it -- especially when the company in question has an easily
understood business model but a balance sheet that looks out of
whack.
Falling Price on Rising Volume and No News
Day Volume High Low Close
03/04/99 357,000 22 1/16 21 1/2 21 3/4
03/05/99 872,500 22 20 1/2 20 11/16
03/08/99 1,705,600 21 19 5/8 19 7/8
03/09/99 2,445,100 19 13/16 17 13/16 19 1/4
03/10/99 2,929,800 19 7/8 17 15/16 18
03/12/99 24,838,600 9 15/16 8 9
As Fools, we don't engage in the mumbo jumbo of technical analysis,
with its support levels and moving averages. We're looking to buy
businesses at good prices. But a "market signals" approach suggests
that markets act with the collective voice of all buyers and sellers and
can "tell us" things -- like "the outlook is brighter" or "clouds are on
the horizon." Fundamental investors should often take these signals
as a call to investigate. Where are the clouds coming from? Will they
pass over, or produce a flash flood that will wipe out the college
education fund?
The rising volume and falling prices depicted in this table suggest that
the market starting seriously entertaining Safeskin's disaster days
before the warning came. Did someone in the company inadvertently
tip off an institutional investor, who heard a slightly different tone
when he asked how things were going? Or did a hedge fund shorting
the stock have some particularly compelling discussions with
distributors suggesting that Safeskin would finally be skinned? Who
knows. Yet, in light of the questions already in the air, the trading
action last week suggested investors might have good reason to
worry.
Is Safeskin now a value at about 9 times trailing earnings? Maybe,
but I wouldn't touch it with latex gloves. First, management has lost
credibility, big time. The inventory problem didn't just sneak up on the
company, as Jaffe suggested in the earnings warning. Milberg Weiss
and friends will hound Safeskin with lawsuits, and perhaps rightly so.
Second, the FY98 numbers don't count now. They aren't literally
phony, but investors have to mentally revise them even if the auditors
don't. Reported sales definitely outpaced real end-user demand,
inflating profits massively. The question is how much. Third, the
company's warning mentioned increased price pressures, with gross
margins dropping from 52% to perhaps 46%. Lower sales, lower gross
margins and a management team you can't trust. No wonder the
stock is down 80% since July. |
