Do Nu Skin Inventory Red Flags Spell Trouble Ahead?


Last Friday morning, a comment posted on Twitter by Marc Cohodes about Nu Skin Enterprises (NYSE: NUS), a Utah based multi-level marketing company, caught my curiosity. Cohodes is a legendary short-seller with an excellent track record and looks for "fads, frauds, and failures" involving public companies. He wrote, "The Clown who runs NUS tried to squeeze shorts. Screw him! He will get what's coming to him in spades one day. Too much Inventory is an issue." Afterwards, I decided to take a close look at Nu Skin's financial reports. So far, my first issue is that management's explanation for its massive increase in inventory levels does not square against its own historical numbers, guidance it gave to investors, and analysts' consensus estimates. In addition, Nu Skin may be have to take significant margin reductions to unload its excess inventory and possibly have to recognize a material impairment charge against inventory in a future period.

Background

Generally, if a company is efficient at managing its inventory levels, its inventory and cost of goods sold should grow in tandem over time. If a company becomes more efficient at managing its inventory levels, its cost of goods sold will grow faster than inventory reflecting shorter periods of time to turnover its inventory into revenues. However, over the last seven quarters, Nu Skin's reported inventory levels grew significantly faster than its growth in cost of goods sold resulting in longer periods of time to turn its inventory into sales.

A more troubling issue is that Nu Skin's reported revenues exceeded its own maximum revenue projections while its inventory turnover decreased for each of the last seven quarters. In two of those seven quarters, Nu Skin beat its maximum revenue guidance by over $90 million. Generally, it provided revenue guidance for the current quarter approximately 4 to 5 weeks into same quarter. Therefore, Nu Skin already possessed several weeks of sales data before it provided revenue guidance for the entire 13 week quarterly period. Since Nu Skin's reported revenues exceeded its most optimistic forecasts within a relatively short period of time, its inventory turnover should have increased because it should have ended the period with fewer inventories on hand than it had anticipated. However, an analysis of Nu Skin's numbers indicates that it is taking progressively longer periods of time to turn its inventory into sales.

Calculations

Days-Sales-in-Inventory (DSI) measures the number of days it takes for a company to turn its inventory into sales. DSI is computed as follows: (Ending inventory/Cost of goods sold during the period) X number of days in period. If the DSI number grows over time it indicates that a company's inventory turnover is decreasing because it is taking longer periods of time for a company to turn its inventory into sales. In general, a growing DSI could indicate one or more of the following potential red flags:

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