Check Out The Cash Cycle
The cash-conversion cycle does not make headlines, and you'll rarely hear investment pundits pounding the table for a stock based on how fast the company turns inventory into cash flow it can invest.
However, the cash-conversion cycle is an excellent gauge of operating efficiency. To calculate the cash-conversion cycle, also called the cash cycle, we add the number of days needed to sell inventory and collect receivables, then subtract the time the company takes to pay its bills.
The QuadrixÂ® cash-conversion trend score, a component of the Financial rank, measures the cash cycle relative to the median over the last three years. This score has historically been somewhat effective at identifying stocks that outperform. In rolling 12-month periods since January 1992, the average stock in the Dow Jones U.S. Index of large, medium-size, and small stocks returned 12.4%, while the top one-fifth of those stocks as measured by the cash-conversion trend score returned 12.8%.
Not surprisingly, the cash cycle varies greatly from industry to industry. For instance, the average cash cycle for chemical companies in the Dow Jones U.S. Index is 74 days, while the average telecom company takes longer to pay its bills than to convert inventory into cash. Companies that process raw materials and sell finished goods to business customers on credit often take a while to turn over inventories and receivables.
Many companies have negative cash cycles, generally because they take a long time to pay their suppliers. The telecommunications sector, which holds very little inventory and collects from customers in an average of 29 days, averages a cash cycle of -24 days. In some cases, a negative cash cycle can be misleading, because not all companies have the ability to consistently make suppliers wait on payment. However, large and financially strong companies often enjoy more latitude in this area. And in some industries, long payback periods are the norm.
When looking at cash cycles, it makes sense to compare a company to the average for its industry rather than to the market as a whole. All 15 of the A-rated stocks in the table below have cash cycles shorter than their industry average. All have also seen their cash cycle improve over the last three years. Three of the companies are reviewed below:
Altera ($33; ALTR) has managed a cash cycle of 33 days, less than half of the industry average, 67 days. In the past year, Altera has grown sales 54%, along the way decreasing by 7% the number of days needed to transform inventory into sales. Free cash flow has risen in five consecutive quarters, including a 180% jump in the September quarter. That growth has helped revitalize Altera's balance sheet, which now holds net cash of $1.91 billion, or $6.04 per share, versus $2.90 per share a year ago.
A cyclical recovery has helped drive Altera's growth. Altera supplies semiconductors for a range of products, including consumer electronics, vehicle navigation systems, medical devices, and cellular networks. Its geographic markets are as diverse as its product line. Last year, only 20% of Altera's revenue came from North America, while 58% was generated in Japan and elsewhere in Asia. Earning a Financial Strength score of 97 and Overall rank of 99, Altera is a Focus List Buy and a Long-Term Buy.
Laboratory Corp. of America's ($82; LH) cash cycle of 33 days is below its three-year median of 40 days and the average of 43 days for its industry. As the second-biggest U.S. clinical-laboratory operator, LabCorp has carved out a 9% share of a highly fragmented $65 billion industry.
Opportunities for organic growth could be limited, but LabCorp has built a reputation for successfully integrating smaller labs into its operations. By one estimate, LabCorp has completed or announced $1.25 billion in acquisitions in the past year, augmenting annual revenue by more $600 million. One of its largest and most recent deals, the $925 million purchase of Genzyme's ($71; GENZ) genetic-testing business, earned U.S. regulatory approval in November.
Going forward, LabCorp could explore forming partnerships with large drugstore chains to boost volumes and improve customer convenience. The consensus projects per-share-profit growth of 14% this year and 10% next year. LabCorp is a Buy and a Long-Term Buy.
TJX ($46; TJX) turns its inventory into investable cash in just 24 days â€” more than a month faster than the average apparel retailer. TJX's current conversion rate is also one-third quicker than its three-year median, a direct result of improved inventory management.
Number of days inventory is down 9% from last year and has dipped to 11% below the discounter's three-year median. By turning its inventory over quickly, TJX can keep its shelves full of fresh apparel and preserve a treasure-hunt environment. Tight inventory controls also help maximize profits during periods of weak sales.
Wall Street sees roughly flat profits in the January quarter, followed by 10% growth in fiscal 2012 ending January, down from the 19% growth anticipated for the current year. But management also sees opportunities to trim inventories further. TJX is a Buy and a Long-Term Buy.