Cintas’ Obsolete Masks
Does CTAS’s inventory reserve hold a stash of future earnings?
Good analysts like it when things are predictable. They like to see nice, steady trends in the numbers. Nowhere is that more important than with reserve accounts. If reserves such as bad debt allowances or warranty reserves are not tracking with a certain degree of correlation to the assets they adjust, analysts should start asking questions.
One often overlooked trend is that of the inventory reserve. When a company places an item in inventory, it records the cost it incurred to either acquire or produce that item. However, stuff happens in the real world. Items can be stolen, lost, damaged, spoil, or become obsolete before they are sold. As an asset account, inventory should never be recorded at more than its realizable value. Therefore, a contra account in the form of an inventory reserve is used to reduce the carrying amount of the inventory on the balance sheet to reflect the company’s estimate of how much the above factors will eat into the value of its inventory before it is sold.
Below we will explore how earnings can be distorted by changes in the reserve and then take a close look at recent trends in Cintas Corporation’s (CTAS) numbers. We estimate the recent drop in its inventory reserve could have added as much as 9 cps to the most recent quarter’s EPS and hold as much as 30 cps that could be released into future earnings.
Potential Red Flags
When a company adds new units to inventory, it establishes a reserve by recording an expense, typically in cost of sales. Over time, if inventory losses are higher than expected, the company can reduce the carrying value of inventory by increasing the reserve account and recognizing an expense which is typically recorded in cost of goods sold. Likewise, if losses are lower than originally expected, the company can increase the value of the inventory by reducing the reserve and recording a credit to earnings.
As we said above, good analysts are fond of steady trends and should investigate any unusual movements in the inventory reserve that don’t line up with changes in inventory. Either an unusual increase or an unusual decline in the reserve could result in an artificial benefit to earnings in either the current or future quarters. We find it helpful to calculate the reserve as a percentage of gross inventory and track that measure over multiple years. This allows for the analyst to establish a reasonable value range that can put any deviation in perspective and help isolate the probable cause.
Considerations with a declining inventory reserve
If the reserve percentage tracks steady and then starts to trend down, it could be signaling that the company is reserving less for current inventories than it has in the past. It is important to remember that even if the new reserve policy proves to be economically reasonable, the year-over-year decline in the reserve will result in an artificial tailwind to earnings until a year after the new percentage had stabilized.
Considerations with an increasing inventory reserve
A sudden increase in the reserve percentage likely indicates a specific event that led to the loss in value of a portion of the company’s inventory. We have seen this in recent quarters with companies that paid premium prices to stock up on personal protection equipment (PPE) to satisfy demand during the initial phase of the pandemic. After initial demand for these products died down, many companies determined that the fair value of this inventory had fallen below its net value on the balance sheet. If a company disposed of such inventory, the reserve percentage would not have been impacted as the reserve and the inventory would have been erased altogether. The associated charge would have hit earnings and most likely been added back in today’s non-GAAP world.
However, in many cases, these companies anticipated they would sell these inventories later, likely at a reduced price. Reserves specific to these PPE inventories were increased, resulting in these companies taking a hit to earnings. As with write-offs, these extra expenses were often characterized as one-time items and added back to non-GAAP earnings. While higher expenses may not seem aggressive at first glance, the potential distortion comes later if the company either decides the inventory has regained value and it reverses part of the reserve back into earnings, or it later sells the inventory at higher-than-expected prices and realizes artificially high profits as a result.
We highlighted an unusual trend in the inventory reserves at Cintas (CTAS) for our institutional clients which we will examine below.
The Jump in CTAS’s Reserve
CTAS provides its customers with uniforms for their workers as well as other work-related consumables such as first-aid and cleaning products. When the pandemic hit, demand skyrocketed for PPE products to protect workers and CTAS paid top dollar to ensure it had PPE inventory to satisfy as much of the demand as it could. However, by the 5/21 quarter, demand had settled down and prices had fallen which led it to write down the value of this PPE inventory. The following table shows the calculation of the inventory reserve for the last sixteen quarters.
By looking this far back, we can see that the reserve percentage prior to the pandemic was running in the 9% range before the 5/21 charge more than doubled that level. The company offered little in the way of explanation. The 5/21 10-K stated:
“Inventories are recorded net of reserves for obsolete inventory (excess and slow-moving) of $111.0 million and $45.5 million at May 31, 2021 and 2020, respectively. The inventory obsolescence reserve is determined by specific identification, as well as an estimate based on Cintas' historical rates of obsolescence. The disruption created by the COVID-19 pandemic beginning in the fourth quarter of fiscal 2020 resulted in larger quantities of inventory on hand as of May 31, 2021 and 2020. As of May 31, 2021, our Uniform Rental and Facility Services and First Aid and Safety reportable operating segments held an excess amount of personal protective equipment inventory on hand. The excess inventory, determined through specific identification, resulted in an increase to the obsolescence reserve of $43.6 million as of May 31, 2021, in comparison to May 31, 2020. As of May 31, 2020, an incremental obsolescence reserve was recorded within our Uniform Direct Sales operating segment due to larger quantities of inventory remaining on hand, at the consolidated balance sheet date, as a result of disruption created by the onset of the COVID-19 pandemic.
Obsolete inventory reserves are recorded in selling and administrative expenses on the consolidated statements of income. The judgment applied to increase the obsolete inventory reserve as of May 31, 2021 and 2020, beyond our historical policy was deemed to be reasonable and supportable based on the data available as of the consolidated balance sheet dates. Once a specific inventory item is written down to the lower of cost or net realizable value, a new cost basis has been established, and that inventory item cannot subsequently be marked up.”
Management stated the following in the conference call for the 5/21 quarter:
“Operating margin increased 660 basis points to 19.4% in the fourth quarter of fiscal '21, compared to 12.8% in the fourth quarter of fiscal '20. Fiscal '20, fourth quarter operating income was affected by many items caused by COVID-19, including additional reserves on accounts receivable and inventory, severance and asset impairment expenses and lower incentive compensation expense. Excluding these items, the fiscal '20 fourth quarter operating margin was 15.5%. All of these items were recorded in last year's selling and administrative expenses.
Note that the statement in the conference call is not referencing the huge increase to the reserve in the 5/21 quarter but rather the much smaller increase in the 5/20 period. We asked the company for more detail on the reserve spike but it could not comment beyond what was disclosed in the conference call or SEC filings.
The 10-K for the year ended 5/22 indicated that the portion of the reserve related to PPE had fallen to $28.5 million at the end of the year versus the initial $43.6 million in last year’s fourth quarter. We assume the decline is related to some of this inventory being sold. It is possible that margins on these PPE sales are artificially high because of writing down the cost basis. We are not especially worried about that, particularly given the company’s reference to recent margin growth benefitting from a shift in mix away from lower-margin PPE versus other products. However, what we are concerned with is the peculiar decline in the reserve in the 8/22 quarter which we look at more closely below.
Why the Sudden Drop in the Reserve?
What stands out as unusual about the reserve is the sudden drop in the 8/22 quarter following four straight quarters of being relatively flat at the elevated level. Let’s look at the data the company has disclosed on the reserve during that time:
It took all of FY22 for the PPE reserve to decline by $15.1 million, likely from selling off PPE inventory. We don’t have PPE reserve data for the 8/22 quarter, but we see the total reserve declined by $11.2 million despite total inventory increasing sequentially. We doubt the decline in the reserve was a result of the company selling PPE inventory given that would imply it sold almost as much PPE inventory in the 8/22 quarter as it did in all of fiscal 2022. It seems more likely that the company either reserved much less for recent inventory purchases or it reversed some of the reserve back into profits. Given its specific statement in the 10-K that once inventory is written down it cannot be marked up again seems to rule out a reversal which points to the possibility that the company is reserving less for new inventory purchases.
This leads us to the fact that the non-PPE portion of the reserve is still significantly higher than it was before the pandemic. Below, we show our estimate of the non-PPE reserve as a percentage of non-PPE inventory for the last four fiscal years. We assume that the PPE reserve wrote the inventory down to half its value, so our estimate of gross PPE inventory is simply two times the PPE reserve amount:
Our estimate starts with reported net inventory and removes the estimated net value of the PPE inventory. We then add the known value of the non-PPE portion of the reserve back to get an estimated gross core inventory which we use to calculate a core reserve percentage. We see that the current core inventory reserve level stands at almost 14% compared to just 9% before Covid (FY19) and only 10% in the middle of the pandemic (FY20). (And remember from above, the jump to 10% warranted a comment in the 10-K and the conference call.)
It appears to us that there is quite a bit of fluff in the inventory reserve that is not related to PPE which makes the unusual decline in the 8/22 quarter even more concerning.
Putting This in Perspective
The $11.2 million decline in the inventory reserve had the potential to add almost 9 cps to earnings in the 8/22 quarter. Longer-term, the total reserve as a percentage of gross inventory is still at almost 16% versus the more normal 9% range which we estimate leaves another 30 cps of potential benefit from a continued reduction in the reserve. This trend should be watched very closely in the upcoming quarters and profit growth accompanying a decline in the reserve should be viewed with skepticism.
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