Detecting Deteriorating Operating Margins and Increasing Capital Intensity

As one would expect, deterioration in operating margins will occur in economic slowdowns. Marginal competitors frequently will try to clear inventories at ever lower margins in order to generate cash flow. I am particularly interested concerned if a company exhibits not only operating profitability deterioration but also a build up in working capital intensity (i.e. accounts receivable and inventories may be building and cash is not coming in as quickly as one would like.) Finally, if at the same time, the company is building capital expenditures, free cash flow generation can be impeded.

In this screen, I am taking trailing four quarter observations and comparing these to trailing four quarter observations lagged back one year prior. I have confined my screen to non-financial stocks in the S&P 1500.

There is no attempt to scale the amount of deterioration. For example, in 3M (MMM), a company which I continue to like, the operating margin has decreased from 22.57% to 22.53% - hardly alarming. Operating working capital to revenue has increased to 14.1% from 10.35% which still represents significant improvement from working capital levels which hit 20%+ levels of two years ago. Similarly, capex at 3M, as it undertakes its international expansion is at 7.52% of revenues versus 6.94% four quarters prior, again, not an alarming pace. The bottom-line is that this is a screen which is designed to raise some questions and further analysis, not to prompt an instant sell or a short.

The data is from Cash Flow Analytics, a company founded by Professor Chuck Mulford of Georgia Tech.

Finally, the ultimate test of investment is a test of market price versus intrinsic value, clearly a judgment that each investor should make for him or herself.

You will find the screen in this link: http://tinyurl.com/3oayag.

Disclaimer: I, my family, or clients have a current position in 3M.