COMPASS MINERALS INTERNATIONAL, INC. (NYSE:CMP) Accounting and Earnings Quality Review Sept. 3, 217 Significant Accounts Review Accounts Receivable Accounts receivable were 9% of assets at September 3, 217. Receivables as a percent of revenue is in a general upward trend, with fluctuations in between. Rising receivables indicates the Company is not collecting receivables as quickly as it used to, which may result in receivables write-offs and lower operating cash flows. Exhibit 1: Accounts Receivables and Revenue: FQs ($ in millions) 4 AR (Gross) 149 136 74 117 33 236 186 221 Revenue 289 346 17 18 443 388 228 291 Gross AR % Revenue 52% 39% 43% 65% 74% 61% 81% 76% 9% 8% 7% 6% % 4% 3% 2% 1% % To better understand what s happening with receivables collection, we look to the days sales outstanding, which tells us how fast the Company is collecting receivables. DSOs shown in Exhibit 2 mimic the fluctuating upward trend observed in receivables to revenues in Exhibit 1. DSOs have increased each of the last three quarters (year-overyear). This confirms that the Company is taking longer to collect its receivables, which, as mentioned above, could lead to write-offs and lower operating cash flows. Exhibit 2: Accounts Receivables and DSOs: FQs ($ in millions) 4 AR (Net) 148 135 72 115 321 226 176 21 Revenue 289 346 17 18 443 388 228 291 DSO (Net) 45 37 56 48 45 64 81 61 9 8 7 6 4 3 2 1 Page 1 of 6
Next, we take a look at what is happening with allowance for bad debts, to gauge receivables risk. Exhibit 3 paints a picture of concern, as the Company is setting aside larger amounts for allowance, which tells us management is expecting bad debts to rise. As the dollar value of receivables rise, we do expect uncollectible amounts and allowance to rise as well. What is troubling though, is that management saw it fit to increase the allowance as a percent of receivables. Allowance to receivables has been around 5% the last two quarters, and almost doubling from year-end 216. This confirms our concerns about rising receivables and the potential impact on earnings and operating cash flows. Exhibit 3: Accounts Receivables and Allowance: FQs ($ in millions) 12 6% 1 5% 8 4% 6 3% 4 2% 2 1% Allowance for doubtful accounts 1 2 2 2 9 9 9 11 Allowance / Gross AR.9% 1.2% 2.2% 1.5% 2.7% 3.9% 5.1% 4.9% % Inventory Days Inventory Outstanding (Inventory Holding Period) Inventories are a fairly decent chunk of CMP s assets, at 14% as of September 3, 217, so naturally we want to see what s happening with those inventories. At 133 days in Q3 217, days inventory outstanding are high. However, it s fallen for the last four quarters, which is a good sign, and suggests management is doing a better job managing inventories. Demand for CMP s products depend a lot on whether conditions, which makes it tricky to manage inventories. Holding too much inventories can lead to excessive holding costs and obsolescence risks. It is therefore important that the Company manages its production efficiently to avoid holding too much inventories. Exhibit 4: Inventory and DIO by Quarter ($ in millions) Inventory 275 211 241 273 281 238 288 336 DIO 13 91 161 174 76 77 131 133 18 16 14 12 8 6 4 2 Page 2 of 6
Production If you ve read our reports before, you know we like production to be less than cost of sales. If you re producing more than you re selling, you will eventually have an inventory buildup. CMP s production has been higher than cost of sales for six of the last eight quarters. It is therefore not a surprise that its DIOs are consistently over days. We suspect that the difficulty in planning how much salt to produce for snow in the winter is wreaking havoc on CMP s inventory management. Unfortunately for the Company, there s not much it can do about this, as it has to ensure it has adequate salt in case the winter is bad, but might up with too much inventories if the winter turns out to be mild. Until someone figures out a way to precisely predict the weather, the Company will continue to face uncertainty in its inventory management. Exhibit 5: Production by Quarter ($ in millions) Inventory 275 211 241 273 281 238 288 336 Cost of Goods Sold 191 243 128 134 333 36 183 214 Production 198 179 158 166 341 263 233 262 Production to COGS Ratio 13% 74% 123% 124% 12% 86% 127% 122% 14% 12% % 8% 6% 4% 2% % Property, Plant & Equipment Property, plant and equipment is the largest asset for CMP, making up 47% of its balance sheet. PP&E is usually not a risk for most companies. It becomes a risk when a company is not performing well, and these assets may become impaired, and result in an impairment loss for the company. We didn t see real impairment risk at the end of Q3 217. Profits have fluctuated, and the Company made a loss in Q2 217, but operating cash flows have been steady for the past two years. Goodwill and Other Intangible Assets Goodwill and other intangible assets make up 23% of CMP s total assets. Goodwill and other intangible assets derive their values based on how the underlying business is performing. If the part of the business to which these assets are related is performing well, then goodwill and other intangibles will maintain their values. Otherwise, the company might have to take an impairment loss if the business is performing poorly, and values for intangible assets can no longer be justified. CMP s goodwill and intangible assets do not exhibit near-term risk of impairment, for the same reason PP&E does not appear to be impaired. CMP s market capitalization is more than two times its book value, a sign that investors believe the Company s intangible assets are worth their carrying values. Page 3 of 6
Exhibit 6: Goodwill and Other Intangible Assets ($ in millions) 3, 2, 2, 1, 1, Goodwill 62 61 61 412 417 43 422 Intangible Assets (Net) 85 88 87 85 158 155 151 Total Assets 1,629 1,651 1,657 2,453 2,472 2,39 2,316 2,447 Goodwill / Total Assets 3.8% 3.7% 3.7% 16.8% 16.9% 17.5%.% 17.2% Other Intangibles / Total Assets 5.2% 5.3% 5.2% 3.5% 6.4% 6.7% 6.5% 6.2% 2% 18% 16% 14% 12% 1% 8% 6% 4% 2% % y Debt and Liquidity Debt is by far the biggest liability on CMP s balance sheet at September 3, 217, comprising 54% of liabilities and equity. Debt is over $1.3 billion, and has remained high since it almost doubled in Q3 216 due to debt incurred to fund an acquisition. The debt-to-equity ratio was almost two at September 3. High debt puts pressure on a company to generate sufficient cash flows to repay the debt and fund operations. The Company s operating cash flows have fluctuated, but appears adequate to pay interest and fund operations. As an investor, I would pay close attention to the cash flows and interest expenses. The high debt might hamper the Company s ability to acquire other companies to grow its business. Exhibit 7: Debt and Debt-to-Equity Ratio by Quarter ($ in millions) 1, 1, 1, 8 6 Total Debt 723 718 7 1,213 1,325 1,232 1,256 1,329 Total shareholders' equity 645 72 684 667 717 73 693 747 Debt to equity ratio 1.1 1. 1.1 1.8 1.8 1.7 1.8 1.8 2. 1.8 1.6 1.4 1.2 1..8.6.4.2. Page 4 of 6
Earnings Quality Analysis Overview CMP s earnings have been on a bit of a rollercoaster ride, with more down thrills than up thrills. Net profit margins have declined three of the last four quarters (year-over-year). When analyzing earnings quality, we try to answer questions that might tell us something about a company s. These include questions around source of earnings and earnings sustainability. Exhibit 8: Net Income and Net Income Margin, by Quarter ($ in millions) 12 25.% 8 6 4 2 2.% 15.% 1.% 5.%.% -2 Net Income / (Loss) 58 6 9 98 22-6 32 Net Profit Margin 2.1% 14.3% 3.6% 5.1% 22.% 5.5% -2.8% 11.1% -5.% Are Earnings from the Core Business? Looking at the Company s revenues and costs for the last nine months, we don t see any non-operating items flowing through the income statement. However, we did see interest expense increase by $23 million, which is financing cost and an operating cost. This lowered profits, but was more than offset by a $32 million turnaround from a tax expense in 216 to a tax benefit in 217. We do not consider taxes to be a part of the Company s operations, and therefore net income got a boost from this non-operating item. Are Earnings Recurring or Non-recurring? The Company cannot expect to have this tax benefit windfall continue indefinitely, so net income growth could be tempered by the lack of this benefit going forward. To What Extent Are Earnings Subject to Management Judgment? To answer this question we usually look to what the company says about estimates it makes in its financial statements. The more estimates, the more subjective earnings are, because they are more susceptible to estimation errors, whether intentional or not. Items that the Company disclosed as requiring the most judgment include mineral interests, which are included in PP&E and which values are based on estimated probable reserves. Estimating reserves require significant judgment, and could in impairment losses if the estimated reserves cannot be recovered. Mineral interests are amortized through earnings over their estimated useful lives. The Company estimates the useful life, and the longer this useful Page 5 of 6
life, the lower the periodic amortization expense. The useful life estimate ultimately determines how much amortization expense hits the income statement each quarter. The Company also lists income tax as another item that requires significant judgment. As we discussed in the first question, the Company s earnings had a big boost from changes in tax expenses over prior year. CMP listed other areas of significant judgment that could have a big impact on earnings. These include revenue recognition, allowance for doubtful accounts, valuation of inventory reserves, valuation of equity compensation instruments, derivative instruments and environmental accruals. Our review of these items did not identify any untoward issues related to the Company s earnings. Are Earnings Converted to Cash in a Reasonable Time? For the answer to this question we look to the cash flow statement to see what s happening with operating cash flows. As you can see from Exhibit 9, operating cash flows have been greater than net income about half the time. From the pattern we are seeing, it s clearly a seasonal business, with cash flows greater than earnings in the first two quarters, then falling behind in the third and fourth quarters. While we re concerned that operating cash flows are not consistently above earnings, these concerns are offset to some extent by the fact that the discrepancies appeared to be caused by seasonality. Exhibit 9: CFFO & Net Income, by Quarter ($ in millions) 14 12 8 6 4 2-2 -4-6 Net Income / (Loss) 58 6 9 98 22-6 32 Operating cash flow 43 93 57-43 68 123 2-16 Overall, we consider CMPs earnings quality to be fairly decent. Earnings are volatile, but appear to be driven more by the Company s dependence on nature rather than management playing around with estimates. Page 6 of 6