A.M. Castle Teaches a Lesson in Inventory Accounting

When considering companies for investment, it is easy to take a lazy approach by quickly scanning financial statements and forming conclusions based solely on the numbers. Unfortunately, companies make accounting choices which can drastically alter the meaning of its financial data.

One such choice concerns the accounting treatment of inventory: FIFO vs LIFO. While in the majority of cases this difference is not large enough to matter, it can make substantial differences in a handful of companies, and in the extreme case it could be the difference between a "buy" and a "don't buy"!

Consider A.M. Castle (CAS), a metals and plastics distributor. While it currently lists inventory at $232 million, it has made a conservative accounting choice (LIFO) that not many companies make; its inventory would actually be listed at $340 million were it to adopt the more prevalent FIFO method of inventory accounting.

While this may not seem like a noteworthy distinction (and in many cases, it isn't), consider how this affects the net current asset value of CAS compared to its market value [click to enlarge]:

Clearly, investors who took the time to evaluate the company's financials by digging deeper than what's on the surface could have found value that others had missed. For a discussion on A.M. Castle's suitability as a potential value investment, see this article.

Disclosure: Author has a long position in shares of CAS.

Comments

[LSF:]

Saj, a good find but you also have to keep an eye on a possible hidden downside that allows the company to recognize more earnings simply by dipping into their LIFO inventory "surplus" over the past year, the inventory FMV less LIFO reported inventory (the LIFO "surplus" dropped from $134mn to $111mn from March '08 to '09. This would have increased reported earnings by $23mn just due to "inventory management" rather than increased sales.

Jun 08 08:29 PM

[Saj Karsan:]

Hi LSF,

You're absolutely right, you have to watch for that on the earnings side. This was more about the balance sheet tho.

PS Note also that due to taxes the earnings would have increased by more like $14 mill using your numbers.

Jun 09 01:53 PM

[LSF:]

Saj, True, I should have indicated pretax profit or operating income instead of net. Also, the $23mn Lifo impact was all in Q1 2009 (total Lifo impact for all of 2008 was about $8mn).

My point was that these "hidden" assets can also create less obvious but significant impacts on the earnings and cash flows of the business that would need to be considered (they are all part and parcel of the same issue.)

For example, in the A.M. Castle situation the use of the Lifo 'reserve' has caused a significant acceleration of the 'buffering' of earnings in Q1 2009. Reported operating income for Q1 2009 was $2mn ($22mn for Q1 of 2008.) Taking into account the Lifo impact, this would have lowered Q1 2009 operating income by $23mn to a ($21mn) operating loss. Remember, this impact was only $8mn for all of the year 2008. This would also have a big negative cash flow impact if/when this inventory is replaced at current market prices.

I'm just pointing out the hidden dangers on and beyond the balance sheet for this kind of "hidden" asset. I agree with you that these types of situations can present hidden opportunities, but your original premise in your post above is very relevant: that companies make accounting choices which can drastically alter the meaning of its financial data that require more than just a scan.

Jun 09 09:14 PM