Byrne's Eye View

From the first time I read Security Analysis, I used to vaguely think that a high current ratio was a sign of a good stock to follow: if a company has lots of inventory to dispose of and receivables to collect, they can generate cash even if they run into operational problems. I recognize that this hasn't been the conventional wisdom during my lifetime, except perhaps in the late 80's and again a year or two ago, when an LBO firm really could swoop in and turn those inventories into cash. But now that I've read this thorough but not especially compelling biography of Harold Geneen, I've learned to look at a current asset-heavy balance sheet with actual revulsion¹.

So when I look at the recent financial statements of Adam's Golf (freshly-listed on the Nasdaq, ADFG), I recognize the kind of company that, as recently as a year ago, I would have seen as a screaming bargain. Their current assets are about $30 million each of inventories and receivables, along with about $1 million in cash. Their current liabilities total $20 million, so this (profitable) company's $36 million market cap puts it at a 10% discount to the value of assets that are, in accounting theory, convertible to cash within a year. A one-year 11% CD with a net income attached doesn't sound like a bad deal.

But looking over their history reveals that this company is a mess: over the last five years, sales have not quite doubled, but inventory has risen from $9.13 million to $28.75 million, and receivables are up from $8.55 million to $18.01 million. So it looks like they have to grow their capital base faster than their earnings, which should lead to perpetual disappointment from stockholders, along with the occasionally lurch in profit thanks to an obsolescence writedown or a bankrupt customer. Their cash flow statement confirms this: their net income melts away into higher working capital, so even though the rest of the cash-flow statement doesn't show anything, the business is barely able to hold their cash on hand stable while keeping up their growth.

And get this:

A significant portion of our inventory purchases are from one supplier in China; we purchased approximately 46% and 62% of our total inventory purchased for the years ended December 31, 2007 and 2006, respectively, from this one Chinese supplier. This supplier and many other industry suppliers are located in China. We do not anticipate any changes in the relationships with its suppliers; however, if such change were to occur, we have alternative sources available.

That's right: their business model is to hope that their Chinese partner doesn't hire an American salesman. These guys are extracting a gross margin of 43% for having a few friends among end retailers. I'm betting that this unnamed supplier could find a salesman who wants less than a 43% commission.

If this were a letter attached to a 13-D, I might include a few suggestions:

• Curtail expansion. Don't take on another product line or customer unless the necessary increase in working capital is less than the increase in earnings.


• Take a look at existing product lines and customers, and any time you can liquidate 10% of your inventory and receivables at the cost of a 9% or less drop in earnings, do it.


• Quickly -- quickly -- get that cash back to shareholders through dividends (if you announce the gradual liquidation in advance) or buybacks (if you don't).


• Consider whether it's really worth it for a small company to be public at all. Filing reports and complying with SarBox is expensive. Are shareholders really getting benefits from all this activity? The company's most valuable asset seems to be their deferred tax asset. There's a chance that shareholders could benefit if the company bought out some high-profit cyclical business in order to shield a few years of great earnings. But the expense of finding a company, buying it out, and actually making the carryforwards apply could be too much for this to be worth it.

There might be a good company hiding in the mess that is Adams Golf. If there is, it's probably too small to be public. If there isn't, nobody is likely to take Adams private. It must hurt shareholders to sell their stock at four times last year's earnings, and at a discount to net current assets besides. But I fully sympathize with the sellers who have knocked the company's value down by 33% in the three months it's traded on the Nasdaq. I don't know how cheap the company deserves to be, but it looks like management is gradually chipping away at the company's business value, and raising the risk the company faces at the same time. The small chance of better management is not worth the risk that, five years from now, the company will once again be selling twice as much, and hauling around four times as much in current assets to do so. This is no way to run a business.

[1] A little of this is because Schoenberg's biography treats accounting as a very dramatic subject. Perhaps that's because Geneen's biography is mostly about accounting until the very end, when he's mixed up in some nasty bribery scandals. So Schoenberg has to treat the overhaul of depreciation schedules or the revamping of inventory monitoring as some kind of high heroics. The shareholders at Jones & Laughlin, Raytheon, and ITT certainly could have considered Geneen a hero for his work at those companies.