Thursday, August 28, 2008

Inventing Inventory, Part II

Two days ago, we considered the huge gap in inventory valuations at A.M. Castle (NYSE: CAS). On the one hand, a LIFO valuation tells us the inventory is worth $248 million. But the replacement cost of the exact same inventory is listed at $423 million. Thinking as a value investor, if you were to buy this company (or a piece thereof), which (if either) of these valuations would you rely on? Since the company's market cap is just $470 million, it's an important question!

What we want to know is the market value of that inventory. The key to answering this question lies in determining how much someone (i.e. a customer) is willing to buy the inventory for. Just because the inventory has a high replacement cost ($423 million) does not mean anyone will actually buy these goods for that much!

On the other hand, the LIFO amount ($248 million) is the one that is stated on the balance sheet. This amount has to be written down to the lower of cost or market (as per Note 8 to the quarterly financial statements), so at least we know the inventory is not worth less than that (according to management). But how much more than that are its customers willing to pay?

Consider taking a look at the company's gross margins. Here we get a hint of how much above the company's cost of the goods that customers are willing to pay. Last quarter, sales were approximately 30% higher than COGS.

As an approximation, we may be able to surmise that the inventory carried at $248 million can be sold for about 30% higher than this number, bringing the market value estimate of inventory to about $322 million.

Of course, this method is not perfect. Can you see any potential problems that we can rectify? Would you expect the actual market value of inventory to be higher or lower than the $322 million estimate we just calculated?


heterocedastico said...

Usually when an inventory stays inhouse for a long time and LIFO is used, in an inflactionary scenary, the inventory is going to get undervalued because you're selling the last bougth inventorory (costly) and keeping the oldest (cheaper). For valuing correctly inventory the best method is to use FIFO.

Companies that use LIFO usually provide a number called LIFO Reserve that added to LIFO inventory will equal FIFO inventory.

Best Regards

Saj Karsan said...

Hi Hetero,

The problem comes in when they report a LIFO (as done here) and provide a FIFO in the notes. Unfortunately, you have no way of knowing that even though the goods would cost a lot to replace, that they can be sold at this high value! So that's where our challenge comes in.

heterocedastico said...

So if I understand it right your replacement cost IS the FIFO inventory!

I think that if you use the company margins (that use LIFO on COGS, so its the margins on the most recent inventory) to get the inventory market value you wont get accurate numbers because you are computing old inventory numbers with recent inventory margins.

I think the market value of inventory is better valued with FIFO inventory.

Now if you want to calculate the value of inventory on a liquidation situation, that's more complicated... I dont have the sensetivity to different kinds of inventories and the markdowns the each one would need to be sold.. I believe you used a markdown of 50% for the inventory of amisco. Its certanly a conservative measure...