1 Important Risk with UG Healthcare Investors Should Note

Latex glove maker UG Healthcare would be listed in Singapore’s share market soon. At noon tomorrow, the company’s public offer to the general public will close. UG Healthcare’s consistent revenue and profit growth, as well as its low valuation at listing, might make it seem like a possible investment candidate right off the bat.

A steady grower at a cheap price

The chart below, which I borrowed from my colleague James Yeo’s article on the five things you should know about UG Healthcare’s initial public offering (IPO), shows the company’s top- and bottom-line growth.

UG Healthcare income statement

Source: UG Healthcare IPO prospectus

Valuation wise, James also mentioned in his article that UG Healthcare’s going public at just 8.2 times its earnings for FY2014 (financial year ended 30 June 2014). For some perspective, the SPDR STI ETF (SGX: ES3), an exchange-traded fund which tracks Singapore’s market barometer the Straits Times Index (SGX: ^STI), is valued with a price/earnings (PE) ratio of 13.5; meanwhile, fellow glove maker Riverstone Holdings Limited (SGX: AP4) carries a trailing PE of 13.9.

But just because UG Healthcare has a cheap valuation and had enjoyed steady revenue growth in the past does not mean that investors would automatically be getting a bargain – UG Healthcare can still disappoint investors if it can’t grow its business in the future. And on that note, there seems to be some clouds on the horizon.

The warning sign

In 1987, investor and author Thornton O’glove penned a book titled Quality of Earnings which aimed to teach individual investors how they can increase their chances of spotting shares which might have potential problems in the near future.

One of O’glove’s tools would be inventory analysis. More specifically, investors ought to be alert when inventory grows at a much faster rate than revenue. As O’glove wrote:

“[E]xcesses of inventory, time and time again, is a good indicator of future slowdown in production.”

When inventory growth spikes while sales growth meanders, it could be a case of a company’s products being obsolete, or an overestimation of customer demand on the company’s part. Both scenarios are clearly not beneficial for any firm’s business.

UG Healthcare’s numbers suggests that it might have that issue.

Healthy demand… not?

UG Healthcare inventory and revenue growth

Source: UG Healthcare IPO prospectus

As the chart above shows, the company’s inventory has been growing much faster than revenue; in FY2014, inventory increased by 33.9% whereas revenue only inched up by a relatively meager 4.2%.

But, it’s not always a bad thing to see inventory-growth being much higher than revenue-growth. A company’s inventory can be further split into three items: 1) Finished goods; 2) works-in-progress; and 3) raw materials. If most of a company’s increase in inventory comes from a spike in raw materials, it can be a good sign. That’s because when companies see higher demand ahead, they tend to bulk up on raw materials in order to meet that demand. O’glove even thinks that a decrease in finished goods and an increase in raw materials is worth celebrating – he calls it a positive inventory divergence.

A deeper dive into UG Healthcare’s inventory is no consolation, however.

UG Healthcare's inventory analysis

Source: S&P Capital IQ

The chart immediately above shows that the bulk of UG Healthcare’s inventory growth in FY2014 had come from works-in-progress and finished goods. In particular, finished goods actually surged by 95% from S$1.92 million in FY2013 to S$3.74 million in FY2014.

A Fool’s take

To summarise, UG Healthcare’s inventory has been growing at a much faster rate than revenue, and that might be a problem for the company in the future. Furthermore, a breakdown of its increase in inventory also shows that the source of growth is not exactly the best either.

This does not mean that UG Healthcare would certainly be in trouble in the years ahead. There are strong tailwinds for its business (such as rising international healthcare standards which would pump up the demand for medical gloves), as James shared in his article I referenced earlier. Management also seems confident of demand growth in the future, as can be seen from the following statement found in the prospectus:

“As we were not able to fulfil our orders in full in the past due to, inter alia, our production capacity limitations, we expect the volume of our sales to increase in tandem with our larger production capacity and the steady growth in demand for latex examination gloves.”

But, even if there’s a strong bull case for a company, it’d still pay for investors to think about the risks too. My look at a key risk for UG Healthcare’s business can help in that endeavor.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore writer Chong Ser Jing doesn’t own shares in any companies mentioned.