Last week, Baker Hughes (BHI) reported earnings of $1.00 a share, beating expectations of $0.77 a share (conference call). As a result, the share prices jumped over 9% and several analysts upgraded their estimates. I was surprised, since I had previously written a bearish article on BHI, and had held a short position for a while (fortunately price action had me close out that position before the recent price spike).
Despite beating EPS estimates, BHI also reported Q2 revenues of $5.33 billion. While YOY revenues were up 12% compared to 4.74 billion for Q2 2011, they were down 0.5% compared to $5.36 billion for Q1 2012.
So how did such a beat happen despite a quarterly sequential decline in revenues? BHI bought more inventory. Inventories grew, year over year, by 29.6%, while sales only grew 12.3%. In the June quarter, inventories grew 4.6% sequentially while sales dropped -.54%.
How did buying inventory improve profit margins? Look at this equation for cost of goods sold:
COGS= Beginning Inventory + Purchases - Ending Inventory
Since one subtracts Ending Inventory, any increase in inventory, not in close relation to sales, will lower cost of goods sold. As an example, consider the following hypothetical figures:
Begin Inventory = 500
Purchases = 500
End Inventory = 600
COGS = 500 + 500 - 600 = 400
Now, let's change End Inventory to 700
COGS = 500 + 500 - 700 = 300
One can see that by just buying inventory, this hypothetical company has lowered its cost of goods sold by 100. No more sales were made, but "costs" have dropped by 100.
BHI has "kicked the can down the road," so to speak. It has improved costs today at the expense of increased costs in the future. Inventory levels will eventually align themselves to sales growth, which aligns in the long run to economic growth.
I am skeptical of a company that grows inventories over 29% a year while sales increase 12% a year, and while the global economy has averaged 7% growth from 2000-2010.
Let's look at BHI's Inventory Turnover = Sales / Average Quarterly Assets
(click images to enlarge)
You can see that BHI has not been generating as much sales for its level of inventory over the last several quarters. I also have reversed this ratio as average inventory/sales.
We can see that having inventory at about 70% of sales is historically high for BHI. I believe that the global economic recession explains the spike in the above chart in 2009. Sales fell over -12% in June of 2009, while inventory dropped -3.8%.
We can also see that inventories make up an all time high, since December 2004, of working capital:
We have now figured out the answer to the riddle of how BHI managed to "beat the Street," but how would its earnings have looked if more inventories were not purchased?
To answer this question, I made a "pro-forma" income statement with the COGS represented by different levels of inventory as a percentage of sales. Historically, when the global economy was not in recession, it appeared as though BHI held an inventory level between 60-65% of sales. Look below, at what happens to BHI's net income and earnings per share if inventory had been allowed to fall to these percentages of sales.
Last quarter ending inventory was 71.5% of sales. We can see that if BHI had not increased inventory by $168 million, it would have missed estimates. In the March 2012 quarter, BHI had an ending inventory of 68.03%. The above table shows that if BHI had added inventory to 68.5% of sales, it still would have "missed" earnings estimates by $0.03 a share. (My figures pulled depreciation out of "Cost of revenue," then calculated COGS and added back depreciation -- data from ADVFN.)
We can see what problems to net income would be created if BHI adjusted inventory levels to more historical levels of 60-65% of sales. At 60% inventory to sales, BHI actually would have lost money! At 65%, BHI only earns $0.41 a share.
Another point for investors and traders to consider is provided in Table 1 of BHI's press release. This table shows net income a year ago, adjusted for the extraordinary loss of assets in Libya. Excluding this cost, BHI had net income of $408 million at the time. This year, BHI made $439 million, using their numbers, with net income growth of just 7.6%, while inventories grew $872 million from one year ago.
Do not be fooled by the lower EPS numbers as a result of the asset losses in Libya, even if you don't agree with my analysis. Computers can access the database of bottom line net income, divide by the shares outstanding, then spit out EPS. It still takes a human to ponder how those numbers came to be.
Additionally, BHI's financials aren't favorable when looking at free cash flow as expressed in the formula below:
Free Cash Flow to the Firm = Op Cash Flow + [Interest x (1 - tax rate)] - Capital Expenditures
For June 2012, BHI had -$608 million of Free Cash Flow to the Firm, which is another indication that the company is using balance sheet grease to drill for income statement earnings.
I will keep looking for opportunities to short again in the future.