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Bidz.com, Inc. (NASDAQ:BIDZ) has recently been scrutinized for its low free cash flow that is responsible for negative net cash balances. In addition, Bidz.com’s inventory levels and appraisal methods have been questioned by publications such as the Los Angeles Times.

The inventory issue is particularly important according to the Joseph T. Wells (Founder of the Association of Certified Fraud Examiners). In an article published by the Journal of Accountancy, Mr. Wells wrote that “inventory overstatements made up the majority of asset valuation frauds”. He went on to state:

Dishonest organizations usually use a combination of several methods to commit inventory fraud: fictitious inventory, manipulation of inventory counts, non-recording of purchases and fraudulent inventory capitalization. All these elaborate schemes have the same goal of illegally boosting inventory values.

Inventory Risks at Bidz.com

The Journal of Accountancy report provided 10 questions used to evaluate the probability of inventory fraud. According to Mr. Wells, “the more “yes” answers, the higher the risk for inventory fraud”. The following analysis applies these tools to Bidz.com’s inventory:

  • Is the company attempting to obtain financing secured by inventory? Yes

In July 2006, we entered into a revolving credit line agreement with LaSalle Bank (Bank of America), to provide working capital financing secured by inventories and tangible assets.

Source: Bidz.com Form 10-K Filed on March 12, 2008 with Securities and Exchange Commission

  • Is inventory a significant balance sheet item? Yes

Over the past three years, Bidz.com’s inventory has comprised between 78.3% and 89.7% of its total assets. This compares to 13.0% and 10.6% in 2007 for competitors Blue Nile, Inc. and Overstock.com, Inc. respectively.

Source: Form 10-Ks Filed with Securities and Exchange Commission

  • Has the percentage of inventory to total assets increased over time? Yes

Bidz.com’s inventory has significantly increased as a percentage of total assets from 64.3% in 2001 to 89.0% in 2006. See table below (click to enlarge images):

Source: Bidz.com Forms Filed with Securities and Exchange Commission

  • Has the ratio of cost of sales to total sales decreased over time? Yes

The Company’s ratio of cost of sales to total sales has decreased over time, as illustrated below:

Source: Bidz.com Forms Filed with Securities and Exchange Commission

  • Have shipping costs fallen compared with total inventory? Information not available in Securities and Exchange Commission filings.

  • Has inventory turnover slowed over time? Yes

Bidz.com’s inventory turnover has significantly decreased from 8.5x in 2003 to 3.3x in 2007 (as shown below). In addition, the Company’s turnover is substantially below its most direct competitors of 15.3x and 31.2x in 2007 for Blue Nile, Inc. and Overstock.com, Inc. respectively.

Source: Bidz.com Forms Filed with Securities and Exchange Commission

  • Have there been significant adjusting entries that have increased the inventory balance? Information not available in Securities and Exchange Commission filings.
  • After the close of an accounting period, have material reversing entries been made to the inventory account? Yes

In 2007, Bidz.com’s inventory reserve increased 133.2% over the previous year’s balance.

Source: Bidz.com Form 10-K Filed on March 12, 2008 with Securities and Exchange Commission

  • Is the company a manufacturer, or does it have a complex system to determine the value of inventory? Yes

Bidz.com’s valuation methods for its jewelry have been criticized by numerous groups. The Los Angeles Times had this to say about their “appraisals”:

Bidz.com often offers buyers an "appraisal" of their item for a $33 charge. The reports are invariably produced by Woodland Hills-based American International Gemologists, which acknowledged to The Times that it does not physically inspect every item for which it provides an appraisal.

That raised a red flag for Jeanine Woodling, director of education at the nonprofit International Society of Appraisers. For a solid appraisal, "It's important for them to actually be able to see the piece," Woodling said.

  • Is the company involved in technology or another volatile or rapidly changing industry? Yes

Consumer tastes and preferences for jewelry products can change rapidly, thereby exposing us to significant inventory risks.

Source: Bidz.com Form 10-K Filed on March 12, 2008 with Securities and Exchange Commission

Results: It appears that the answer would be “Yes” for 8 out of 10 questions and inconclusive for the remaining two. According to Mr. Wells’ work, this would indicate a higher risk of inventory fraud.

Bidz.com Cash Flow Concerns

Partially as a result of its inventory issues, Bidz.com’s operations do not generate cash. The Company’s net cash position is negative and substantially lower than its competitors as illustrated below:

Source: Forms Filed with Securities and Exchange Commission

In addition, the Company’s cash flow from operations and free cash flow are becoming increasingly negative.

Source: Forms Filed with Securities and Exchange Commission

Investment Considerations

Taking the inventory and cash flow concerns into account, investors should be cautious.

Disclosure: Author has a short position in BIDZ

Source: Bidz.com: Inventory and Cash Flow Concerns