Saturday, January 19, 2008

Increasing Whole Sale Prices

Consider that wholesale prices are up 6.4%. I am not sure the degree to which this is a problem, but I picked two stocks to have a quick look at. McAfee has a market cap of about $5 billion and 160 million shares. My first glance is that the wholesale price increases will hurt them less than other businesses. Their cost of revenue for the last five quarters, starting with 09/06 and going to 09/07 is 22.3%, 22.6%, 22.2%, 22.7%, 24.2%. It has taken a jump in the last quarter, but overall their cost of revenue is low so wholesale prices increase should not hit them as badly as say a company with say 60% cost of revenue. They have this "other" income that I haven't a clue as to what it is and I'm not inclined to spend hours trying to find out. It is about 30% of the earnings so it is a fairly serious wild card that has the potential to seriously hit the earnings.

So, looking at McAfee, my instincts are whole sale prices are a lesser issue with this company, but the "other" income could be. The taxes being paid is an enormously serious issue with this one. I just noticed it. Those same 5 quarters the percent taxes go 33%, 28%, 22%, 17% and 5%. With that "wouldn't we all like to see our tax burden decline like that" reduction in taxes paid for each of the past 5 quarters earnings have gone 0.21, 0.20, 0.27, 0.29 and 0.39. The number of shares is increasing every quarter, up to 165 million diluted shares now. With proportional taxes to a year ago last quarter's earnings would have been 27c/share, so this tax game has inflated the last quarter's earnings by 44%. Typically the executives of companies understand the short term nature of the inflation of earnings from tax benefits and use these events as a Richistan liquidity events, and cash out their options. They often also make the event even more lucrative for themselves by initiating share buy back programs which gives them an even greater spread on their stock options.

Ok, so the wholesale price isn't such an issue with McAfee, but the artificial inflation of earnings due to tax benefits is enormously serious. With an economic slowdown there should also be a bit of a hit to earnings and a slight margin squeeze. I haven't taken the time to really dig here, but I see that eps predictions for this year are $1.62 and $1.75 next year. Wanna bet the analysts are way wrong yet again? The lows are $1.37 and $1.53 with the highs at $1.62 and $1.75 respectively. I suppose if the tax benefit remains for the whole of next year, all of next year could be inflated earnings, but real earnings without the tax benefits is probably in the $1 range, making this about a $20 stock. Well, that look went off on a tangent...

The other one I picked to look at is Crocs. Their cost of revenue for the same last 5 quarters goes 41.8%, 42.3%, 40.5%, 40.9% and 39.4%. They've done a good job in actually reducing the cost of revenue in a highly inflationary period, but not enough to make up for the diluted number of shares increasing by 5.5% over the period. Their growth has been enormous, but it looks like that is coming to an end. They have 4 times as much inventory as they had a year ago.

I don't know about the rest of you, but for me, most footwear I buy lasts a few years, especially seasonal footwear. I think that Crocs has probably done the market penetration thing so that they have to wait a few years for repeat business and now they are relying far more on the "I don't care about a fad" kind of buyer. I don't have a pair of these things, but for me, if I did, either they are good enough that I wouldn't be buying because I have a pair and I wouldn't need another pair for a few years, or they were garbage so now I know where I don't want to spend my money again.

This enormous growth of inventory is potentially a problem. The product is too new to say for sure. I am very curious about what the next earnings report says. Last year from the 09/06 to 12/06 quarterly reports sales increased by about 1%, so essentially flat. Well, this past quarter the revenue was 2.4x the year earlier. What you have to be asking here is how much of the sales is to give the retailers a selling inventory and how much is actually being sold to consumers? How much did retailers sell at fire sale prices to clear space for other seasonal products? How much do retailers just leave on the shelf year round? How successful will they be with their higher priced spin-offs? I think this one has enormous uncertainty, but the next financial report will give a much better idea of which way this company is going. If they have over capacity for supply their earnings are going to hurt because there is a certain fix cost and should the overall sales volume decline, that will squeeze the margin, both in a proportional increase in fixed costs and a decline in revenue. Another tangent...

So, setting out to have a peek to see how wholesale costs increasing would show up in financial reports did not really show that with my look at a total of two companies...

However, in the macro economic picture, and with a simple mathematical model, this is how it should work. Consider 4 companies and the only variable is the wholesale costs. Each company trades at a P/E of 20. The wholesale costs make up, respectively, 20%, 40%, 60% and 80% of costs. The wholesale costs increase to 21.26%, 42.52%, 63.78% and 85.04%.

At a P/E of 20, the shares are trading at a price that has the earnings left over at 5% of the market cap. For simplicity, I will look at two examples, one where 10% of revenue made it to earnings and one where 20% of earnings made it to revenue.

For the 10% example, now you have 8.74%, 7.48%, 6.22% and 4.96% now making it to earnings, for declines in earnings of 12.6%, 25.2%, 37.8% and 50.4%. In order for the share price to correct to back to a P/E of 20 the share price must decline by these amounts respectively, or the new P/Es would be 22.9, 27.0, 32.2, and 40.3 respectively.

For the 20% of revenue making it to earnings the wholesale price increases are less damaging, causing declines in earnings of 6.3, 12.6, 18.9, and 25.2% respectively.

If the company is operating very tight and has say only 5% of revenue making it to earnings, well, these companies are in big trouble with the increases in wholesale prices.

So this very simple look at whole sale prices suggests that companies with the lowest cost of revenue and greatest percent of revenue making it to earnings will basically outperform the market, however, even though they will take the smallest squeeze on earnings, all companies will face some degree of squeeze on earnings. This is probably very good criteria to use to in deciding which stocks that are far more likely to be hurt with increasing wholesale costs. Of course there are many other variable to consider, such as debt, pricing power to offset costs, etc.

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