You got to know when it is real and when it is just paper.
Fundamental research is not modeling or tinker with assumptions or about better forecasting as most shops ask of you. Fundamental analysis is about knowing action and reaction and know how to take advantage of the misaligned information. To sum up, when there is dissonance, attack. These dissonances can be internal or external. Able to catch them is the difference.
To sum up, when there is dissonance, attack.
You need to be able to listen to the dissonance and react to them right in time. What I mean by that is investing is an observation game of action and reaction. To be good at it, you need to learn the dynamics, the rhythm, the structure, the melody, the instrumentation, the texture, and the harmony. These are things that they don’t teach you in MBA or CFA. I want to share it with you. I hope you will find these useful and apply them to the management’s music and profit sustainably.
Inventory Step Up
Step up involves the concept of paper vs real money. Take a look at below:
The total inventory fair value step up was valued at $3.8 million and was recognized into cost of revenues over one inventory turn, or approximately five and a half months.
The cost of sales percentage was also negatively impacted by $1.1 million from the step up to fair value of R-22 refrigerant inventory acquired in the ARI acquisition that was sold in the three-month period ended March 31, 2018.
Operating income for the three and six months ended June 30, 2014 included $0.5 million and $1.8 million, respectively, of purchase accounting inventory fair value step-up adjustments in cost of sales upon the sale of inventory.
All of these shared one thing; inventory step-up negatively impacted cost of sales. For some analysts, they will see a revision to mean on net revenue and possibly will cause them to ditch the investment. However, you shouldn’t do that. The ability to lower taxable income is a moment that every CFO can’t wait. Step up reduces tax basis and delivers surprises in the future quarters. It is an excellent tool to manage the stock price.
Less taxable income for the firm.
Why? Say company A brought company B for 500 million dollars. The 500 million is a sunk cost. They can only recoup by making the operation better. However, management can change how much the inventory is worth. By step up the inventory to “fair value,” management lowered their paper margin and equity analysts’ future expectations. However, the reduction does not affect their cash gains. They still make the same amount of money but pay less taxes.
What is also very common is that management will claim that they were able to sell all of the acquired inventory in one quarter. That is just very hard to believe. At least for me. So the impact is only a quarter but few analysts will focus on this. Those who do can profit from what’s coming up next.
It means lower future expectation on margin
Connected fitness gross margin was 40.5%, driven by continued product cost improvement, helped by the Tonic acquisition and better-than-expected leverage in our logistics platform.
With a meaningful improvement in operating margin, capital investments made in 2019 for new stores, the acquisition of a distributor in Italy and in our China joint venture totaled approximately $35 million and better position the company for future growth.
Gross profit in the third quarter increased over 8% to $253.5 million, gross margin of 33.3% improved 90 basis points from 32.4% a year ago, primarily due to favorable price cost dynamics, principally in wallboard, steel and other products; acquisition related purchasing synergies, mostly from Canada; as well as end market and product mix.
So, every one of these reported higher cost of sales the quarter after the acquisition. Then when everyone thought that their growth is stalled, they swiftly came back with the above. You won’t have to think twice about what happened after. Their stock price went up 30% on average in the next few days. So, to profit, you combine your ability to discern “bull shit” with your ability to spot “paper losses.” and step-up is one of those you can use.
That is all for today. I hope you find these interesting and useful.