Sweet Nothings at FMS

Uri Ronnen
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Uri Ronnen

An equity analyst is a lot like a journalist. The journalist writes articles, the analyst writes reports. Both generally have two kinds of information: that in the public domain, and that whispered into the ear by somebody who has an interest in the information reaching the public domain. The result may be a distorted version of reality.

Both the journalist and analyst have the same fear. If they annoy their source, be it a minister or paper-pusher or the CEO or some veep, they may lose that informant. A political correspondent in say Washington needs the informational shots in the arm as badly as any addict, and in exchange, deliberately or not, he may present the versions of these unnamed sources as independent commentary. Reporters like that have come to be called "access journalists".

In November last year, media critics appended that soubriquet to Bob Woodward of the Washington Post and Judy Miller of the New York Times, after the public learned that the Bush administration had used them to disseminate disinformation about weapons of mass destruction in Iraq. Bush wanted to prepare public opinion ahead of an invasion. A colleague of Miller's from Newsweek told the weekly radio show On The Media, that the New York Times had constantly tried to tie Miller to another reporter: she had access to the top and would bring the story, while he would analyze it critically and check its veracity.

Bob Woodward moved easily behind the closed doors of the White House, explained the radio show host, and therefore wrote narratives from the viewpoint of the powers that be. Readers were offered intimacy with the powers, without analysis, but what wins in Washington is analysis, he concluded.

Later the host noted that a blogger had been the one who forced the White House to admit that white phosphorus had been used as a weapon in Iraq, shortly after denying that very thing to the mainstream press. The blogger had simply read the artillery corps magazine which described use of the substance in Fallujah. Access journalists quoted the powers and were useless, leaving the perfectly available material to be found and read by amateurs, the host said.

Access analysts

And all that came to mind this week as I read a report by analyst Shahar Brenner of Psagot Ofek, about FMS Enterprises Migun (TASE: FMS), which makes armoring and materials to protect its clients, cars and personnel, against ballistic threats.

Brenner published his report on June 20, when FMS was trading at NIS 203 per share on the Tel Aviv Stock Exchange. He recommended buying the share.

Last week FMS collapsed, losing 33% of its value to NIS 140 per share, after admitting that the American army had rejected sample flak jackets as missing quality requirements, and that an NIS 30 million contract would be delayed.

Brenner's report states that it's a reaction to the company's first-quarter report. On the second page, he writes, The company presented substantial increases in outstanding inventory and days sales outstanding - DSO.

Those are two classic warning signs, especially when appearing together. They indicate that the company is having trouble selling the amounts it thought it could, when it thought it could, at the prices it thought it could get.

He pressed the alarm button, and then Brenner promptly turned it off: "To the best of our understanding, this does not portend deterioration of its business environment, just pinpoint events."

For whom the siren shrieks

The financial ratio of days sales outstanding, DSO, examines the number of days between recording revenue, and actual payment by the client. (The numerator is outstanding client debt on the balance sheet, and the denominator is average sales per day, meaning ? total quarterly sales divided by 90, or total annual sales divided by 360).

With FMS, an increase in DSP is a warning sign, for two reasons. One: clients discovering that the company's products fall short of the quality they expected may delay payment until the problems are fixed which increases the numerator. Two: FMS sells not to the end user, but to manufacturers, which use its tiles and textiles to actually make the products. For instance, 40% of its 205 sales were to Honeywell, which uses them in products sold to the American army.

A client might therefore agree to buy more than it immediately needs from FMS. Honeywell might allow FMS to continue shipping it tiles even when its own clients step down orders. It is not unlike channel stuffing among drug companies, and it increases DSO.

Over at FMS, DSO had been growing steadily, from $65 million in the first quarter of 2005 to $80 million in the third quarter, $90 million in the fourth quarter and $115 million in the first quarter of 2006.

Psagot Ofek's analyst brought a table, showing the increase. So why did Brenner write that the pattern represented a one-time event?

In its third-quarter 2005 financial statement, FMS explained that sales had shrunk in the quarter because certain U.S. armed forces were delaying part of their procurement until new standards for bullet proof jackets came into force. If you connect that with the constant increase in DSO, you had to fear the kind of notice that the company got last week, which shot down its stock: its products had failed the test of the U.S. army and FMS would have to provide samples in which the army's comments were applied.

FMS last week also admitted that Honeywell also warned the company of delays in other orders for the provision of other products, because of delays in obtaining final approval from the end customer.

Quality issues with products are not a pin-point event: they are a blanket one. Quality trouble may be the factor behind the skyrocketing DSO, whether because of delays in payment or because of channel-stuffing as orders from the end client ebbed, due to quality concerns. FMS never officially explained the increase in its DSO.

Shares in FMS

Psagot had also noticed that the inventory ratio, which measures the number of days stock is held in inventory (total inventory divided by average daily cost of sales) ? had suspiciously increased. It grew from 18 days in 2004 to 28 in 2005 to 59 in the first quarter of 2006.

There could be many reasons the inventory ratio increases. Some of the reasons could be god ones, such as preparation for huge orders. But when the inventory ratio dramatically increases in parallel with DSO, it probably indicates that the company is stuck with inventory that nobody wants to buy.

So why did the analyst note by the table, that the combination of growing DSO and outstanding inventory is not due to any downturn in the business environment, and that they were pinpoint events?

Psagot also noted that throughout 2005, gross profit deteriorated from 40.3% of turnover in the first quarter to 33.8% in the last quarter. Suddenly, in the first quarter of 2006, it jumped back to 40.4%. The company didn't explain the trend change. Its financial statement published last week brought down its stock, and also showed that its gross margin had shrunk to 31.2% in the second quarter, which the company blamed on a one-time jump in production costs at its U.S. plant, and fierce competition that eroded profits in tenders.

So: The investment bank noted that gross margin shot up from 34% to 40%, outstanding inventory shot up from 28 to 59, and that's a classic warning sign in itself, which the Psagot analysts ignored. The concern is whether FMS was loading production costs onto its inventory ratio, though they should have been booked as a cost in the "cost of sales" section of its P&L statement.

Why did Brenner turn off the alarm?

Securities regulations demand that an executive summary, whether quarterly or annual, present the information that a reasonable investor would need to really understand the company. Specifically, the rules require that it elucidate material changes in the data.

Clearly, throughout 2005 and in the first quarter of 2006, there were material changes in DSO and inventory management at FMS; the Psagot report says so too. Clearly, the reasons for the substantial leap in DSO and outstanding inventory are material to understanding the company, and to drive home the point, Psagot tried to understand what caused the changes.

But Psagot couldn't find the reasons in the company's reports, or in its announcements, and we couldn't either. Brenner wrote that to the best of his understanding, the increase in DSO had been caused by a specific client to which FMS had been forced to extend longer credit, and the increase in inventory was due to delay in an order. Not a downturn in business environment, just pinpoint events.

Those explanations could only have come from a chat with the FMS management: they couldn't be understood from the company's releases. When a company is that opaque, as capital market players insist FMS is - and Psagot Ofek repeats that view in no uncertain terms, then any chat with management automatically creates intimacy, turning the analyst into a sort of "access journalist".

If he had adopted the terms that the press uses, Brenner would have written: "The management claims that the reasons for?", not "to the best of our understanding". Readers should have been made to understand that the company had stated no such thing. Brenner acted as an access analyst, bringing the management version with no objective analysis of his own.

The intimacy superceded analysis, big time. (1) the dramatic increase in DSO could most probably not have originated with a single client, or if it did, the client was Honeywell and the extension in credit terms had to be dramatic. But Brenner didn't inquire why FMS had to extend credit terms. It may have been due to channel stuffing as consumer demand slowed. (2) The dramatic increase in outstanding inventory is unlikely to have arisen from as delay in one order, and if it did, it could have derived from quality issues.

Red flag

Brenner did not closely examine the information. He didn't connect the dots between the information in the public domain, about delays in American procurement until new standards for vests came out, and the results. Nor did he consider the company's statement in 2005 that most of its clients, local and international, receive 60 days' credit on average.

The gap between 60 days and the DSP of 94 days in 2005, and 114 in the first quarter of 2006, should have been like waving a red flag in the face of an analyst. You don't lower the flag to half-mast because of a single sneeze.

Numbers can speak for themselves. There is no need to create intimacy with management and in fact, it can be hazardous to the portfolio. And if you can't help yourself, go protected, and the morning after - check if the sweet nothings management whispered in your ear suit the facts.

FMS commented: "The increase in DSO derived from FMS? acquiescence to extend credit terms of two clients on a one-time basis. That move is not indicative of deterioration in the customer credit terms. The company's reports in financial statements and to investors complied with the law. But the recent events have taught us that following the letter of the law is not enough. We must improve our communications with the capital market and press, and be more transparent."