10-Q Detective

Avnet’s recently announced that it needs more time to tie up its books for the December quarter and will be late in filing its Form 10Q with the SEC. The electronics wholesaler has historically been a timely filer, but asset impairment issues have the Avnet accountants working late. The company says it needs more time to complete tests of goodwill and other intangible assets to determine if the assets are “impaired”—do the assets still have the earning power to justify values carried on the company’s balance sheet?

The December 2008 quarter results included a $10.0 million after-tax charge for restructuring and integration, but made not mention of other unusual charges.  However, in the late filing notice, Avnet disclosed it has already determined that the assets are indeed impaired and that a “significant charge” will be recorded in the December quarter.  It is just a matter of checking the math and then parsing the explanation of just how many apples in Avnet’s barrel have gone rotten. 

It would seem Avnet apples have a very short shelf life, with nearly a third of goodwill and over half of intangible assets arising from a series of twelve acquisitions Avnet completed over just the past two years. Deals done in the frenzy of an equity market bubble rarely hold up well against the test of time.

Avnet held $1.8 billion in goodwill on its balance sheet at the end of December 2008, representing a 30% increase in the last two years. Goodwill is composed of $1.2 billion related to electronics marketing and $644.1 million related to the company’s technology solutions.  The company also had $114.9 million in net intangible assets (last disclosed at the end of September 2008) associated with customer relationships, over half of which arose from the June 2008 purchase of Horizon Technology Group Plc. 

Customer relationships might be the most vulnerable of Avnet’s intangible assets. At the end of last year Avnet claimed relationships with over three hundred of the world’s leading electronic component and computer product manufacturers and software developers.  It is these supply relationships that Avnet uses to serve its customer base of more than 100,000 electronics designers, manufacturers, and resellers.  It is a “who is who” that includes the likes of Siemens, Jabil Circuit, Flextronics, and Garmin.

Jabil is cutting its workforce and Flextronics already charged of all of its goodwill assets in a $5.9 billion charge recorded at the end of 2008. Indeed, it may be Flextronics action, announced just six days after Avnet announced its December quarter results that made Avnet auditors take a second look at the value of Avnet goodwill and intangible assets.

Reporting by contributor Debra Fiakas, who does not hold a financial interest in any stocks mentioned in this article. The 10-Q Detective has a Full Disclosure Policy.

KLA-Tencor Corp., a leading maker of inspection and measurement systems for semiconductor manufacturers, posted a consolidated loss of $434.3 million in the second-quarter 2009 as the weak economy continued to drive a slowdown in demand from its customers. In addition to the bad news that customer demand is forecasted to remain weak for the duration of 2009, as consumers in most countries slash discretionary spending for electronics and other goods that use chips, KLA-Tencor is being hit with another poke in the eye by volatile currency movements. Approximately 83 percent of its operations are concentrated in Europe and Asia, according to the chip equipment maker’s 10-Q regulatory filing.

Although KLA-Tencor attempts to hedge its currency risk, its concentrated exposure to customers in Asia translates into lost profits when the dollar weakens against local currencies. The U.S. dollar emerged from a multi-year slump and gained 4.5 percent against the Euro, but lost 18 percent in value against the Yen last year. And, in China, the Renminbi has gone up 20 percent against the greenback in the past three years. By geographic region, Europe and Japan/China represent about 11 percent and 45 percent of total revenue. Consequently, for the three and six-months ended December 31, the company lost $17.9 million and $81.6 million on currency adjustments.

Chief Executive Rick Wallace told analysts on the second-quarter 2009 earnings call the company saw few signs of any meaningful recovery in business prospects for the third-quarter-and management was guarding against the possibility that chip maker demand-and sales-could actually decline further from already cyclical lows. In my opinion, continued economic weakness in the U.S., coupled with the printing of billions more in paper by the Treasury to prop up a mortally-wounded banking system, will likely weaken the U.S. dollar more against key currencies-translating to additional currency losses for KLA-Tencor in coming quarters.

For the quarter ended December 26, 2008, net revenue was $1.8 billion, a decrease of 17% over the quarter ended December 28, 2007. Total hard drive shipments increased to 35.5 million for the second quarter of 2009 as compared to 34.2 million for the second quarter of 2008. The decreases in revenue resulted from a decline in average hard drive selling prices [16 percent to $51 per unit] during the three months ended December 26, 2008. The decline in our average hard drive selling prices reflect a very competitive pricing environment as a result of all competitors having anticipated more robust demand and consequently having too much supply available for the demand that materialized. The decline in our ASPs was partially offset by increases in unit shipments, which resulted from our continuing diversification into non-desktop markets. For example, we shipped 13.8 million 2.5-inch drives in the three months ended December 26, 2008. This compares to 8.7 million units in the three months ended December 28, 2007. Revenue from all non-desktop PC markets comprised of 65% of hard drive revenue for the quarter ended December 26, 2008 as compared to 54% for the prior-year period.

Prices and margins will continue to erode until end-user demand stabilizes and customers can access credit financing to begin upgading storage systems, which is forecasted to occur in first-half 2010. No matter how one spins it, hard drives exist in a commodity marketplace, where demand and supply balance remain critical. Nonetheless, in my view, Western Digital can stumble through the trough of this economic slowdown by cutting costs. Management told analysts on the second-quarter earnings call it believes the company can remain profitable and cash flow positive by maintaining operating expenses in the range of 9 percent to 11 percent of revenues at a $1.5 billion quarterly run-rate (by “re-sizing” production-slash output-and idling or closing facilities). Although year-on-year the cash conversion cycle more than doubled to nine days, the company threw off $300 million in cash from operations during the December quarter, ending with total cash and cash equivalents on hand of $1.4 billion.

The first one-terabyte hard drive came to market less than two years ago. Does the average consumer really need an additional 1,000-gigabytes of storage? Probably not. But when the global economy turns around, and original equipment manufacturers start pumping out next-generation electronics that gobble ever-larger volumes of digital content, such as graphic files for gamers, mobile devices with multiple applications, home-entertainment systems capable of storing 1,000 movies, and higher capacity business database and external file servers, Western Digital will be ready with its 2-terabyte hard drive.

Human Genome Sciences (HGS) expects to announce a number of positive catalysts in 2009 and believes its current cash position should be sufficient to take the biopharmaceutical company at least through the filing of several marketing applications for products currently in Phase III clinical trials.The company is rapidly progressing toward the commercialization of its two key products in late-stage clinical development, Albuferon (albinterferon alfa-2b) for hepatitis-c and LymphoStat-B (belimumab) for systemic lupus erythematosus. In addition, HGS is awaiting authorization to begin the delivery of ABthrax (raxibacumab) for inhalation anthrax to the U.S. Strategic National Stockpile. Upon delivery and acceptance by the government, the company will record its first product sales (of at least $150 million).

HGS had a working capital shortfall of $57.0 million at September 30, 2008, but the company expects 2009 net cash burn of less than $25 million, compared with approximately $245 million in 2008. Although revenue for the next two years will likely be limited to ABthrax sales, the company could receive milestone payments and/or R&D reimbursement(s) under terms of collaborative and licensing agreements currently in place with Novartis and GlaxoSmithKline (GSK) for Albuferon and Lympho-Stat-B, respectively, according to a November 2008 registration statement:

1. Part of our business plan includes collaborating with others. For example, we entered into a collaboration agreement in 2006 with Novartis to co-develop and co-commercialize Albuferon. Under this agreement, we will co-commercialize Albuferon in the United States, and will share U.S. commercialization costs and U.S. profits equally. Novartis will be responsible for commercialization outside the U.S. and will pay us a royalty on those sales. Novartis and we share clinical development costs. Including a non-refundable up-front license fee, we are entitled to payments aggregating approximately $507.5 million upon successful attainment of certain milestones. As of September 30, 2008, we have contractually earned and received milestones aggregating $132.5 million including the up-front fee.
2. In 2006, we entered into a collaboration agreement with GSK with respect to LymphoStat-B and received a payment of $24.0 million. We and GSK share Phase 3 and 4 development costs, and will share equally in sales and marketing expenses and profits of any product that is commercialized.

In March 2009, HGS expects to report the results of ACHIEVE 1, the second of two Phase 3 trials conducted in patients with genotype 1 hepatitis C. If ACHIEVE 1 is successful, the Company expects that global marketing applications will be filed by fall 2009.

HGS remains on track for its first LymphoStat-B Phase III clinical results by mid 2009 and to have all Phase III results ready for regulatory filings in the fall of 2009. Assuming the studies yield positive results, HGS anticipates filing a biological license application for LymphoStat-B in the United States in the first half of 2010.

Steven Appleton, Chairman and Chief Executive of Micron Technology, visited Taiwan last week for alleged merger talks with its DRAM manufacturing partners Nanya Technology and Inotera Memories in an attempt to win a share of Taipei bailout funds, according to an article in DigiTimes. The ongoing glut in memory chips combined with weakening demand is depressing DRAM prices and straining Micron’s balance sheet, as reported in the company’s first-quarter 2009 regulatory filing:

• The semiconductor memory industry is experiencing a severe downturn due to a significant oversupply of products. The downturn has been exacerbated by global economic conditions, which have adversely affected demand for semiconductor memory products. Average selling prices per gigabit for the Company’s DRAM and NAND Flash products for the first quarter of 2009 [ended December 4, 2008] decreased 34% and 24%, respectively, compared to the fourth quarter of 2008. Average selling prices per gigabit for the Company’s DRAM and NAND Flash products in 2008 were down 51% compared to 2007. These declines significantly outpaced the long-term historical trend. As a result of these market conditions, the Company and other semiconductor memory manufacturers have reported negative gross margins and substantial losses in recent periods. In the first quarter of 2009, the Company reported a net loss $706 million after reporting a net loss of $1.6 billion for 2008.

Micron recorded aggregate inventory write-downs of $369 million for the first quarter of 2009 against $282 million in all of 2008 as a result of the significant decreases in average selling prices for its semiconductor memory products. Future charges could be larger than the amounts recorded in 2009 and 2008, too, if average selling prices for memory products remain depressed or decrease faster than the company can decrease its per gigabit costs, as they recently have.

As of December 4, Micron had one billion in cash on hand at quarter-end, but net free cash flow used was approximately $320 million. Although the company has contractual obligations (notes payable and capital lease obligations) totaling more than $3.2 billion, only $342 million and $487 million are due in 2009 and 2010. However, Micron could be on the hook for an additional $600 million in loan obligations should its 73 percent-owned TECH Semiconductor Singapore joint venture stumble and violate debt covenants.

Looking ahead, it is hard to imagine visibility improving. In the fourth-quarter of 2008, the PC industry suffered its worst shipment growth rate since 2002, as worldwide shipments totaled 78.1 million units, an anemic 1.1 percent increase from the fourth-quarter of 2007, according to results by IT consultant Gartner, Inc.

Falling selling prices for its products — coupled with the need for an estimated $700 million to $750 million in capex spending for 2009 — it is doubtful that Micron can survive in this environment as a stand-alone chipmaker. Micron might find its best financing alternatives rest in Taiwan.

Jabil Circuit Inc. recorded a $318 million impairment charge in its fiscal first quarter 2009 ended November 30. The electronics-components maker wrote-down goodwill in its consumer division — focused on products such as cell phones, telephones, PC peripherals, and set-top boxes — due to the deteriorating economy, tight credit markets and a drop in its stock price. Surprisingly, although its electronics manufacturing services (EMS) segment is more sensitive to the slowing economy, the company concluded that the fair value of the division continued to exceed its carrying value and no impairment was assessed, according to the company’s 10-Q regulatory filing:

• At November 30, 2008, there was $638.3 million of goodwill recorded in the EMS reporting unit. Significant assumptions used in our fair value estimate are discount rates and market multiples. We noted that an increase in the discount rate of approximately 20% for EMS would have resulted in the need for us to perform the second step of the goodwill impairment analysis. In addition, a decrease in market multiples of approximately 7% for EMS would have resulted in the need for us to have performed the second step of the goodwill impairment analysis. If we experience a further significant decline in our stock price and market capitalization, a significant decline in our expected future cash flows, a significant adverse change in the business climate or slower growth rates, we may need to perform an interim impairment analysis under SFAS 142 in future periods, in addition to our annual impairment test, any of which may result in future goodwill impairment charges to the EMS reporting unit. Additionally, there are no assurances that valuation multiples will not decline, discount rates will not increase, or earnings or projected earnings and cash flows of our reporting units will not decline. It is reasonably possible that such changes may occur.

The EMS division, which accounts for 59 percent of aggregate sales, supplies electronic circuit boards used in electronics, instrumentation and medical, and automobiles. However, the company is dependent on a few large customers, such as Cisco, Hewlett-Packard, and Phillips. Ergo, its pricing power is limited. Further, the division competes against other contract manufacturers in India and the Far East, many of which — despite making no profits — continue to pump out products in desperate attempts to meet factory fixed costs during the current cyclical downturn. Going forward, awash with excessive inventory, combined with fading demand in key industries, Jabil Circuit will likely record additional goodwill adjustments in 2009.

IMAX Corporation announced last month that Bradley Wechsler would step down as Co-Chief Executive Officer, effective April 1, 2009, and would assume the position of Chairman of the Board. Wechsler’s alter ego in the shared chairman and CEO positions, Richard Gelfond, will assume full responsibility for the CEO job and relinquish his role of Co-Chairman. The changes, however, bring about new compensation arrangements that might be viewed as somewhat extravagant.Wechsler’s pay for holding the corporate gavel: $200,000 in cash per year plus equity compensation. Gelfond’s salary remains unchanged in 2009 — $500,000 per share plus bonus and stock options. However, in January 2010, a 20 percent raise will go into effect for Gelfond, increasing his cash compensation to $600,000 per year, according to service agreements found in a FORM 8-K filed with the SEC on December 12.

On the surface, the $200,000 per year in cash compensation for the chairman of a company with $104 million in annual revenue (trailing twelve months ending September 2008) might seem a bit steep. Albeit in the case of IMAX it might be considered a bargain, as the total cash compensation for the two positions will decline to $800,000 from approximately $1.0 million in 2008. Of course, as employees of the company neither Wechsler nor Gelfond received compensation for co-chairing the board of directors. Total compensation in 2007 (the last year total figures were reported) was $3.2 million for Gelfond and $2.0 million for Wechsler, including cash, stock awards, option awards and other compensation (such as use of automobiles and payment of life insurance premiums).

One means to judge the wisdom or fairness of executive compensation is “pay for performance” metrics. Revenue rose dramatically in the September 2008 quarter, to $33.4 million, giving IMAX its first quarterly operating profit in a year. Net earnings, however, were still negative after interest expense – and the consensus estimates reflect continued net losses through the end of 2009. Ergo, from the standpoint of its negative bottom line, executive pay looks excessive.

Although profit performance has been erratic, the Wechsler-Gelfond team with its shared work scheme has been one of the driving forces behind the success of the IMAX large-screen format (on screens up to eight stories high and 120 feet wide) for the last ten years. The IMAX management team has big plans for growth in the next two years, with 45 new digital theater systems slated for installation in 2009. In addition, recent deals signal IMAX’s growing appeal to studios. Last month Imax signed a five-movie deal with Walt Disney Co. The agreement puts five Disney movies in Imax theaters beginning in November 2009 with the 3-D movie “A Christmas Carol,” starring Jim Carrey.

Reporting by contributor Debra Fiakas, who does not hold a financial interest in any stocks mentioned in this article. The 10-Q Detective has a Full Disclosure Policy.

Take-Two Interactive Chief Executive Officer Ben Feder told analysts on the fourth-quarter 2008 earnings call the video game publisher was excited about its 2009 pipeline, which would include the first downloadable episode of its Grand Theft Auto 4 for Xbox, Grand Theft Auto - The Lost and the Damned, and new titles from its franchises BioShock, Mafia and the 2K Sports roster. Unfortunately, Feder’s optimism that Take-Two could deliver on new “hit” titles is not borne out by experience. Since its series debut in 1997, the company has become more dependent on its action adventure video game Grand Theft Auto, according to the 2008 regulatory 10-K filing:

• Our latest iteration in the Grand Theft Auto series, Grand Theft Auto IV, was released on the PS3 and Xbox 360 platforms in the second quarter of fiscal 2008. For the years ended October 31, 2008, 2007 and 2006, our Grand Theft Auto titles accounted for 46.2%, 13.1% and 22.4% of our total net revenue, respectively. No other products accounted for more than 10% of our revenue for the year ended October 31, 2008.

However, as a percentage of total publishing sales, the Grand Theft Auto franchise accounted for 60 percent, or $710 million, according to Chief Financial Officer Lainie Goldstein.

The cost to develop a frontline software product can range from $10 million to $30 million. Ergo, it is cheaper — and safer — to roll out sequels. One could question management’s commitment to bringing to market creative, new titles: in 2008, Take-Two spent 28.7% of revenue, or $353.2 million, on software development, an increase of only $32.9 million from the prior year. Albeit management claims to have 36 titles in various stages of development, most of them are retreads of existing games.

In contrast, as the market for video-game titles is characterized by short product life cycles, the company increased its advertising budget by $27.8 million to capitalize on the releases of Grand Theft Auto IV and Midnight Club: Los Angeles.

Management warned on the conference call that it was operating in “a retail environment of great uncertainty.” For full year 2009, Take-Two lowered guidance, and now expects to report earnings of between breakeven and a profit of 20 cents per share — far below consensus analyst estimates of $1.26 per share, as polled by Thomson Reuters. If gamers tire of the antics and action in Liberty City, the company could find itself on the hostile end of another hostile tender offer.

Ten months after Garmin announced plans to enter the GPS (Global Positioning System) — enabled smart phone market, the provider of satellite navigation and communication devices said its Nuvifone has received approval from the Federal Communications Commission. Good news for investors, as more than 70 percent of the company’s current growth comes from sales of personal navigation devices (PNDs) in its auto/ personal mobile series of products — where price is more important than brand to most customers.

Although total unit sales increased 43 percent year-on-year to 3.9 million units in the third-quarter 2008 ended September 27, gross profit margin for the comparable 13-week period of 2008 fell 260 basis points to 44.3 percent, hurt by softer average selling prices (down about 25 percent year-to-date) of its automotive/mobile products, according to the third-quarter 2008 FORM 10-Q regulatory filing:

• Gross profit margin percentage for the Company overall decreased primarily as a result of the automotive/mobile segment remaining a significantly larger percentage of the Company’s product mix during a quarter when this segment’s margin fell by 490 basis points [to 37.7 percent]. The automotive/mobile segment is by nature a lower-margin business and the Company has begun to see the impacts expected on gross margin due to falling prices and a product mix shift toward lower end PNDs.

The Nuvifone is being tested on 1900 MHz and 850 MHz 3G bands. Management is targeting first half 2009 for the product launch. A word of caution, however, to readers banking on smart phone growth to offset erosion in pricing power in the automotive segment: the technology is no longer unique. AT&T already has six GPS-enabled smart phones on the market, including the Apple iPhone 3G, and original equipment manufacturers — from Nokia to Dell – are flooding the market with their own GPS-enabled devices, too. Multimedia player, FM radio, a mega-pixel camera, internet-based functionality — in addition to a wide array of applications, fashion-conscious smart phone shoppers can pick the geometric style and color of their hand sets, too.

Garmin’s core competence is in satellite navigation software — not the marketing of cell phones. The company has yet to name an official carrier; but when it does, I suspect ramping up its promotional and advertising campaigns to build presence in an already crowded market will take a big bite out of margins, too.

In a move to boost sales and profits of higher-margin items like corporate server computers, DELL is offering zero-percent financing to commercial customers. Ironically, the decision to offer easier financing terms comes after word that the PC maker’s financing arm, Dell Financial Services (DFS), reported an increase in credit losses for the third-quarter ended October:

• As of October 31, 2008, and February 1, 2008, customer financing receivables 60 days or more delinquent were $47 million and $34 million, respectively. These amounts represent 3.4% and 2.1% of the ending customer financing receivables balances for the respective periods.
• Net credit losses for the nine-month periods ended October 31, 2008, and November 2, 2007, were $60 million and $27 million, respectively. These amounts represent annualized credit losses of 5.4% and 2.5% of the average outstanding customer financing receivables balance for the respective nine-month periods. –  Third-quarter 2009 FORM 10-Q filing

At October 31, subprime receivables comprised approximately 20 percent of the gross customer receivable balance of $1.5 billion.

To isolate the company from financial risk and improve liquidity, Dell unloads assets to third parties, too. For the nine-months ended October, Dell sold $1.1 billion in fixed-term leases and loans to unconsolidated qualifying special purpose entities, retaining interest of $308 million in some of the securitized receivables. Net credit losses for the period totaled $81 million, up from $55 million in the prior year. These amounts represent annualized credit losses of 7.8% and 6.5% of the average outstanding securitized financing receivables balance for the respective nine-month periods.

In the most recent quarter, global commercial business revenue dropped six percent year-over-year on a unit shipment decline of five percent, reflecting the slowdown in overall global IT end-user spending. As Dell struggles to boost sales in the face of an increasingly gloomy global climate, management obviously believes that offering its business customers more flexible financing options will more than offset the associated credit default risks.