Watchmaker Movado (Nasdaq: MOVA) announced that earnings for its fiscal second quarter increased 36% to $0.34 per share, beating estimates of $0.32. Although reported sales only increased 1%, that figure is distorted by the February sale of the Piaget brand. Excluding Piaget's sales last year, the company experienced a 9% jump in sales. This represents at least the sixth quarter in a row that Movado has topped analyst estimates.
The huge profit increase relative to revenue growth was caused by operating margins expanding from 8.6% to 10.4%. Part of this increase is attributable to the disposition of the Piaget business. For all of last year, Piaget produced total sales of $14.2 million with operating profit of $100,000. If we assume that the $5.2 million in Piaget sales during last year's second quarter yielded no operating profit, the company would have posted an operating margin of 9.3%. The remaining portion of the margin improvement is attributable to higher sales and improved supply chain management.
Considering the company's excellent earnings performance over the past couple of years, I was initially surprised that the stock is trading for about 14x earnings estimates for the current year. In a market where the stocks in the Standard and Poor's 500 index are trading at nearly twice that level, I thought something must be amiss. One of the best places to look in such a situation is the company's balance sheet and cash flow statement.
These statements provide some insight into Movado's low multiple. The company's balance sheet contains accounts receivables for 135 days worth of sales and inventory representing 152 days worth of sales. Offsetting these assets are accounts payable and accrued liabilities representing 44 days of sales. Adding the days sales in receivables and inventory together, and then subtracting the days sales in accounts payable and accrued liabilities, you come up with the company's cash conversion cycle, representing how long it takes to convert revenues into cash. This number stands at a quite lengthy 245 days for Movado.
As a result of the long cash conversion cycle, it is not surprising to see that Movado has had negative operating cash flow for the past two years. Although net income is rising, the related investment in working capital items such as accounts receivable and inventory offset this increase on the cash flow statement. This negative operating cash flow situation means that the company needs outside -- rather than internally generated -- capital to grow its business. Over the past year, the company has increased its debt levels by $27 million. (The Piaget sale provided some cash, leading to a $28 million increase in cash on hand.)
While a long cash conversion cycle causes high working capital needs, the biggest risks to a company in such a situation are the nonpayment of receivables or inventory obsolescence. A sale is never really completed until cash is received. When generous credit terms are extended to customers, the risk that something will happen and payment will not be received rises. On the inventory side of the equation, a high level of watch inventory could become problematic if fashions change. How are you going to unload a warehouse full of last season's watches if no one is interested in buying them anymore?
This morning is the first time I've taken a look at Movado. Even though the company's earnings trend and Price/Earnings multiple look attractive, I wouldn't go barreling into the stock until I became more comfortable with the company's working capital management practices.
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