Saturday, November 17, 2007

McInerney's Assessment

It's always interesting to read up on new ways to assess companies based on their fundamentals. Brian Milner's article, "RIM: out of the stall zone?", discusses Francis McInerney's methodology.
What follows is an excerpt from the article:

Mr. McInerney has developed an innovative means of assessing which companies are likely to exceed even the wildest expectations of the market while others are destined to bitterly disappoint and still others are at risk of squandering huge leads over rivals.

Dedicated followers of his analysis would have jumped on the Apple bandwagon long before it got overcrowded, embraced Google, Comcast and Intel, been wary of Nokia and Microsoft and steered well clear of the likes of Viacom, News Corp., Alcatel-Lucent, Ericsson and the auto makers. They also would have understood why retail giant Wal-Mart continues to brush aside all challengers and why Dell is no longer able to do the same.

But the Canadian expatriate had never subjected RIM to his rigorous formula, an oversight he vowed to correct at the behest of The Globe and Mail.

What he discovered was less than flattering, although by no means a disaster in the making.

RIM started the current fiscal year with a lousy grade of C- from Mr. McInerney, managing director of New York-based North River Ventures. But it has since improved markedly.

“It had a high velocity of capital – operating earnings as a percentage of enterprise value [equity plus long-term debt] – but a mediocre velocity of cash.”

The latter describes how fast a company can turn sales into cash, which is a simple way of assessing how efficient it is at managing its working capital. Those that excel at it get better information at a faster rate from their customers, can afford to take more risks and are more likely to sustain profits.

To measure cash velocity, Mr. McInerney's equation takes days of sales in receivables, adds them to days of inventory and subtracts accounts payable turnover.

Of course, there is more to it than that. After determining how effective a company is in managing cash, capital and the flow of information, he applies an algorithm to come up with grades from A to F, although he doesn't bother with an E.

“After you hit D, there's just no point,” he laughed.

In RIM, Mr. McInerney discovered a relatively slow organization with a strong rate of return.

Michael Dell used to describe such companies as pools of cash waiting for smarter competitors to come along and siphon off their profits.

RIM had a profile similar to Nokia's, which has made them both vulnerable to such predation, Mr. McInerney said. “Companies like this are in my risk zone.”

But in the first six months, RIM slashed inventory days to 21 from 33 and receivables to 57 days from 69. Payable turnover was down to 25 days, indicating that RIM has tightened its supply chain and cleaned up its operations. Its grade is now a more respectable B.

“During the first half, management appeared to have realized how vulnerable it was and seemed to get religion,” Mr. McInerney opined. “If it can get to an A- by the end of the fiscal year, this will indicate a major turnaround. The stock will be a keeper.”

The top-rated companies have closer to 10 days worth of inventory and no more than a month of receivables. Dell, for example, had about five days worth of inventory at its zenith, and its direct-sales business model enabled it to collect from customers before paying suppliers.

The next quarter will tell the tale for RIM, Mr. McInerney said, warning that the company is now in what he calls the stall zone. Why? Because it's much easier to slide backward at this level than it is to improve the fundamentals.

How well you manage the demands of the future depends on the number of cash wait states in your business. McInerney has developed proprietary wait state metrics to gauge your management's ability to navigate the future. You can calculate your company's Management Grade by entering your numbers at their web site.

If his North River Management Grading System throws you an A, you have one of the best performing companies in your sector. If you come up with a C, or worse, you have deep structural problems that you must address immediately. You don't want to tell shareholders after their earnings have evaporated that you got North River's Management Grade F, for free, and did nothing about it!

2 comments:

mariam said...

Nice article. I'm trying to find a tech stock and obviously RIM is a consideration so it's encouraging to see that its in the right direction but is there still value...

White Eagle said...

Thanks for stopping by mariam.

McInerney goes into additional depth on his RIM analysis today at http://www.northriver.com/blog/2007/11/19/rim-at-the-edge/