Friday, April 23, 2010

Masking Poor Results

A rather large percentage of companies experienced declines in revenue in both 2009 and 2008, as the general level of aggregate spending declined in most markets. For most of these companies, these declines can be considered temporary. However, investors must take care not to assume that all firms with revenue declines are experiencing only temporary issues; for some firms, the drops in revenue are part of a secular (rather than cyclical) decline.

The determination of whether a firm's decline in revenues is temporary is part art and part science. We've previously discussed the analysis of the more subjective parts, which involved considering the company's line of business and determining its sustainability. In addition, the investor can take direct clues from the company's financial statements and management's discussion and analysis to help determine the state of the business.

Consider Reliv (RELV), producer and marketer of nutritional supplements and skin care products. The company blamed its poor performance in both 2009 and 2008 on the economic crisis, but further study indicates that the company had problems way before then. Revenues have declined for several consecutive years, and though the company remains profitable, assuming the company's average profits over the last several years represents its earnings power going forward could lead to a poor investment result.

Examination of management's discussion over the last several years does not help assuage fears that the company is on the decline. In both 2007 and 2006, otherwise good years for the economy and companies selling health products, management blamed lower sales numbers on the fact that fewer distributors were able to move its product, and that certain products saw drops in demand. In effect, "our sales were lower because our sales were lower".

Further study of the company's business model also suggests the company's past returns are not sustainable. In 2006, the company generated an ROE of over 30%. Considering most of these products can be copied, and the company's business model can be completely replicated, these kinds of returns invite competition into this category. And that's what appears to have happened, as despite rising health awareness country-wide, the company has experienced several years of decline.

Companies experiencing temporary declines in revenues/earnings can be picked up at bargain prices by value investors. Investors must take care, however, not to assume that all declines are of a temporary nature. Some industries (e.g. the newspaper industry) and some companies are in secular decline, and the identification of such companies is not always trivial.

Disclosure: None

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