As announced during the Company’s first quarter earnings conference call on April 25th, 2007, PMC-Sierra completed a review of its expanded global distribution arrangement with its largest distributor, Avnet, Inc. (AVT) As a result of completing this review, PMC-Sierra determined it was appropriate that all future revenues generated through Avnet be reported on a ‘sell-through’ basis and therefore deferred until inventory is sold to the end customer.

Sell-through provides a more accurate picture of the health of the business and reduces the ease of which distributors can be used to perform channel stuffing. (see here for a discussion of the difference between sell-in and sell-through)

Suppliers of commodity products like memories, generic processors, and passives have a legitimate reason to use sell-in accounting. They have thousands or even tens of thousands of end customers and distributors provide a valuable service abstracting this order flow.

Companies like PMC, which do 80% of their business with a handful of customers, have little reason to use sell-in accounting. In my opinion, they have little reason to use distributors at all for a majority of their revenue.

I expect other component companies are examining the same issue, and unlike PMC, many of them have have plenty of bodies (aka worthless inventory) buried at distributors. The Boards of Directors of these companies should realize that a failure to act may put themselves and the company in a position of shareholder liability if abuse of the channel is not addressed as a governance issue.

PMC appears to made minimal use of sell-in accounting recently and therefore had little to lose from coming clean.

The net impact of this adjustment in the second quarter of 2007 was a decrease in reported revenue of $4.2 million, a reduction of $0.8 million in cost of sales, and an increase of $3.4 million in deferred income on the balance sheet.

AMCC recently announced a massive revenue shortfall, with a large amount of the shortfall due to a massive drop in channel revenue. They claim that this revenue will return. One must wonder if this was a Herculean effort to mop up inflated channel inventory. (see “AMCC Kicks the Distribution Habit“)

It is unclear how much stuffing the channel contributres to distributor revenue. Nu Horizons (NUHC)second largest supplier was Vitesse, which stopped all use of sell-in accounting one year ago. Nu Horizons profitability has slipped in the past 9 months, as I postulated last fall.

Author is short NUHC and holds an immaterial short position in VTSS.

I am at a complete loss to explain the markets reaction to Nu Horizons’s (NUHC) most recent quarterly results. People appear content to follow the herd for now, but the problem with being surrounded by warm bodies is it makes a quick escape impossible.

Nine months ago the company all but guaranteed 4% operating margins by the quarter ending February ’07, which they reported yesterday. Operating margins were at 3.3% last fall when they made this statement. They have declined steadily since then and currently are at 1.2%.

Everything was awful about their quarter.

• Revenue down 9% Q/Q
• Opex Up 2.2% Q/Q
• Gross Margins Flat. No quantitative sign of additional margin from their much vaunted registration business.
• Operating margins declined from 3.2% six months ago to 2.7% to 1.2% in the last quarter.
• SEC subpoenas documents about their #2 supplier, Vitesse Semiconductor (VTSS.pk). Nu Horizons did nothing wrong, but it certainly calls into question the activities of their customers, activities that I feel are highly profitable (See “Trickle Down Economics and Channel Stuffing“), an activity that I feel is on the wane.
• Sun Microsystems (#3 supplier) brazenly announces they will undercut distributor pricing. People have totally missed this. (see Barrons – no subscription required)
• DSO’s on Receivables drop 3rd quarter straight and Payable turns drop 25%. Both are at 3 year lows.
• Net Inventory purchases down for 4th straight quarter. This has been a decent leading indicator of future earnings as NUHC stocks up supplier inventory and recognizes superior margins associated with stuffing activity.

Distributor equities such as Avnet (AVT) and Arrow (ARW) have done exceptionally well in the past six months. I believe Nu Horizons is being lifted by misplaced positive sentiment associated with these companies.

 I fail to understand the long term attraction of these businesses in a global environment that is universally eliminating all high cost middlemen. Why should components, the ultimate commodity, be any different? This should be especially true in the technology industry, the sector catalyzing these global changes in the first place.

Author holds and controls short Nu Horizons and long Vitesse positions.

The company notes a 30% decline in revenue recognized through distribution. They also failed to mention any customer of business reason for the decline. Naturally one can speculate that the revenue shortfall was due exclusively to a decline in revenue shipped through distribution.

According to the latest 10Q filed by AMCC, Avnet (AVT) accounted for 26% of quarterly revenue, or $19.8M or $76M in Dec 06 quarterly revenue. Assuming the shortfall was entirely with Avnet (which is a big assumption) this would result in Avnet based revenue dropping $6M.

Which is exactly what happened – AMCC quarterly revenue dropped from $76M to $70M, a $6M decrease.

An additional $10M reduction is expected to come between now and June-end. Given the lack of any end market or customer explanation (such explanations are usually nonsense anyway) I am left concluding that AMCC decided to kick the channel stuffing habit, something that I’ve been proselytizing companies should do. (click here for related articles)

This is extremely positive (provided you didn’t own the stock yesterday that is). It also opens up an interesting trading opportunity once organic revenue and steady state business resumes.

Provided no underlying issues exist with market or customer demand (networking has shown weakness industrywide) once the channel is flushed and shipments resume, AMCC gross margins should go up and revenue should return to previous levels.

So, for the first time in a long time, I am now the proud owner of an equity stake in AMCC. The conference call is next week and I will be listening.

Author owns and controls a long position in AMCC, VTSS, a short position in NUHC and no position in Avnet.

Expect to see other semiconductor companies investigating their accounting practices. Board members of these companies are probably scrambling in an ass-covering frenzy as I write this.

Vitesse illustrated the way sell-in accounting can be abused, and has moved to a sell-through model since earlier this year. I think this will be an industry-wide trend in an effort to avoid the appearance of impropriety.

Sell-in revenue is recognized when inventory is shipped out from a component supplier, whether it be to an end customer, contract manufacturer, or distributor. Sell-through revenue is recognized only when it reaches the end consumer of the component. The difference is that companies that use sell-in recognize shipments to distributors as revenue, companies that use sell-through do not, unless the sale is non-cancelable/non-returnable. 

This allows companies operating under sell-in accounting to use distribution as a ‘buffer customer’. This has a number of advantages, allowing manufacturers of components to control inventory costs. It also can enable companies to ship product at the end of the quarter to magically hit Wall St. targets.

Component distributors like Nu Horizons (NUHC), Avnet (AVT) and Arrow Electronics (ARW) are the prime beneficiaries from the sell-in practice. Distributors make money marking up goods they receive from suppliers and reselling them to end customers. With sell-in they must pay their supplier when goods are received. With sell-through they pay their supplier only when they sell the goods.

Distributors demand additional margin from companies using sell-in because of the negative liquidity required, and subsequently derive much higher profits, albeit with significantly higher risk. This process has become more profitable with cheap and easily accessible liquidity.

I wrote a long post (see “Trickle Down Economics and Channel Stuffing“) examining the potential risks to Nu Horizons as Vitesse moved from a sell-in model to a sell through model.

Nu Horizons is particularly exposed to this effect because Vitesse is their #2 supplier, and Vitesse will no longer be using sell-in accounting. It is yet indeterminate what impact Vitesse’s accounting change and subsequent operational changes will have on Nu Horizons. It should be noted that Nu Horizons has issued a press release indicating they did nothing wrong, though they have not discussed what impact the Vitesse accounting change will have on their operating income.

If other, larger suppliers of specialty components move away from sell-in, this will have a permanent, long term, and negative structural impact on the P&L’s of distributors as their highest margin business will go away.

In an age of sophisticated just-in-time shipping and real-time inventory management systems there is little need for sell-in accounting. Sell-in can be abused by a supplier to manage revenue and earnings. At its worst, it makes engaging in accounting fraud significantly easier. At best, this leads to lower gross margins in exchange for less revenue and earnings volatility. Personally, I find such a tradeoff unacceptable.

Full Disclosure: I am long Vitesse Semiconductor and short Nu Horizons.

————————————————————————-

I was trying to determine the best way to hedge my Nu Horizons short. Unfortunately, the recent gains in the stock don’t appear to be correlated to their peers or their suppliers.

Xilinx (XLNX) has used Nu Horizons as a distributor for 19 years. Xilinx supplies approximately 1/5th of the product Nu Horizons sells. Not surprisingly, there is a strong correlation between the two companies, at least until June of this year.

Xilinx is an excellent indexing stock for measuring the communication sector. I like to use it as a hedging tool, and considered using it to hedge my short position in NUHC. There’s nothing wrong with Xilinx as an index as it still tracks other companies that sell into the Networking space.

Nu Horizons derives the majority of its revenue from selling into the Communications/Networking market. Yet the correlation between Nu Horizons and suppliers into this market has completely broken down. Vitesse Semiconductor (VTSS.pk), Sun Microsystems (SUNW), and Xilinx sell almost exclusively into the Communications/Networking space, and they account for over half of the Nu Horizons supply chain COGS.

The market clearly believes that Nu Horizons has de-coupled itself from the fortunes of its three largest suppliers, and the Communications/Networking business in general.

What about distribution companies in general? What about the relationship between Nu Horizons and its peers, Arrow Electronics (ARW) and Avnet (AVT)? That’s broken too.

The historical correlation between Nu Horizons and its suppliers, competitors, and end market has broken down. The first break was late summer last year, and the second was June of this year.

One notable event that took place in this timeframe was the signing (warning Word .doc link) of Cameron Associates (info on them here) on May 30th.

This leaves us with two possible outcomes:

1. The market believes that Nu Horizons has fundamentally disassociated itself from its existing suppliers and the customers they serve. After 10 years of correlation to these markets, this time it’s different.
2. Nu Horizons, for any number of reasons, including a theory proposed here, has experienced a short-term surge in investor interest and positive liquidity flows. Once this subsides we will observe a classic reversion to the mean.

“This time is different” can be the four most expensive words an investor can use. I do not see what is different this time. I do not see what competitive advantages Nu Horizons brings outside of the market it has operated in for decades. An analysis I performed of financial metrics important to distributor efficiency (inventory turns, return on working capital) illustrates that Nu Horizons falls short of its peers, Avnet and Arrow.

Nu Horizons has signed up new suppliers outside of the Networking and Communication area and more are probably coming. But it is not clear to me what advantages the company brings to these new consumer markets.

I am short Nu Horizons, long Vitesse Semiconductor.

]]> http://www.nyquistcapital.com/2006/09/20/nu-horizons-is-this-time-different/feed/ 3 http://www.nyquistcapital.com/2006/09/14/trickle-down-economics-and-channel-stuffing/ http://www.nyquistcapital.com/2006/09/14/trickle-down-economics-and-channel-stuffing/#comments Thu, 14 Sep 2006 14:58:04 +0000 Andrew http://www.nyquistcapital.com/2006/09/14/trickle-down-economics-and-channel-stuffing/ It’s very profitable for distributors – while it lasts. I examine the recent disclosures from Vitesse Semiconductor and the potential impact on their largest distributor, Nu Horizons.

McAfee (MFE), the manufacturer of anti-virus software, was alleged to have overstated revenues by $611M from 1998 to 2000 by shipping excess inventory into their distribution channel. McAfee settled with the SEC and paid a $50M fine. The details of what took place are documented in an extensive SEC filing (EDGAR link - read this). The filing highlights not only the activities undertaken by McAfee to enhance revenues, but also the exceptional profit opportunities this created for McAfee distributors.

From McAfee vs. Security and Exchange Commission

McAfee offered its distributors lucrative sales incentives that included deep price discounts and rebates in an effort to persuade the distributors to continue to buy and stockpile McAfee products. McAfee also secretly paid distributors millions of dollars to hold the excess inventory, rather than return it to McAfee for a refund and consequent reduction in McAfee’s revenues. In other instances, McAfee used an undisclosed, wholly-owned subsidiary, Net Tools, Inc., to repurchase inventory that McAfee had oversold to its distributors.

A search of the EDGAR database with the terms “Channel Stuffing” will uncover many more companies that engaged in this behavior, such as Sunbeam and Bristol Meyers.

During a conference call on July 27^th (EDGAR transcript here, my summary here), Vitesse Semiconductor (VTSS.pk) announced it was investigating practices that allowed it to recognize revenue beyond actual customer consumption.

From the conference call transcript:

The cash management techniques employed immediately prior to the quarter end include: the factoring of receivables, shipping large amounts of goods to distributors and negotiating incentives for distributors to remit cash on those shipments prior to quarter end… these activities have stopped.

While the Vitesse situation is much smaller in magnitude when compared with McAfee, it is probable that its distribution partners received incentives like those extended by McAfee. Now that these practices have stopped, consider the following questions:

1. Which Vitesse distributor received these shipments and potentially profited from these transactions?
2. How much operating income did the distributor gain from such transactions? What impact will the elimination of incentives have on earnings?
3. What future risks to this distributor exist if other companies engaging in this practice decide to stop?

If the distributor is small enough, and the supplier large enough, these incentives can be a significant share of operating income and drive increases in operating results.

Which Distributor Benefited?

Vitesse lists only one distributor on it’s website for the US and Asia ex-Japan. That distributor is Nu Horizons Electronics (NUHC). Vitesse also lists a distributor in the United Kingdom – DT Electronics Ltd – which was recently purchased by Nu Horizons.

Email feedback from Nu Horizons confirms that Vitesse is their 2nd largest supplier and accounted for $78.6M (16.6% of FY06 COGS) of total inventory purchases for FY06 (YE Feb. 28 06). Vitesse revenue for roughly the same the period was $199M, therefore 40% of Vitesse revenue was sold through Nu Horizons in the year prior to Feb 28, 2006.

Given that Nu Horizons accounts for the majority of Vitesse distribution, it is a reasonable assumption that they received most of the material Vitesse accelerated.

Vitesse increased FQ106 revenue by $6.4M and FQ206 revenue by $10.5M by shipping additional inventory to distributors. In FQ306, Vitesse burned off $3.1M in distribution inventory by shipping $3.1M less than end customers consumed through distribution. (Note these numbers are un-audited and are Vitesse estimates from the July conference call).

Assuming Nu Horizons was the recipient, this activity would require them to cache $6.4M of unnecessary inventory in their FQ406 (quarter ended Feb. 28 06), and $16.9M (6.4M+10.5M as the deficit was accumulating) in FQ107 (quarter ended May 31 06). The overall inventory level should be reduced by $3.1M to a balance of $13.8M in the current Q207 (Aug 31, 2006).

Vitesse was engaging in deficit financing by shipping more product than needed while still collecting cash. Their distribution partners provided the cash flow and in exchange carried excess inventory.

What was this Transaction Worth?

Insufficient information exists to reach a quantitative conclusion about what financial gains Nu Horizons could have derived from this transaction. The franchise agreements with suppliers that spell out contact terms are not available to investors. However, just as McAfee distributors realized lucrative incentives from accelerated shipments, it is likely Nu Horizons realized some short term benefits from Vitesse shipment acceleration.

Suppliers typically ship inventory to distributors at the end of the quarter, therefore Vitesse shipments made during their FQ106 (December 31, 2005) would be received during Nu Horizons FQ306 (Feb 28, 2006). Vitesse Q206 shipments would be received in Nu Horizons Q406.

Distributors demand additional compensation to stock inventory beyond a given time frame, usually 90 days. It appears that Nu Horizons carried a large quantity of material for Vitesse, and it is unclear what compensation was received in return. However, any compensation that was received was revenue with radically higher operating margins than Nu Horizon’s component distribution business.

Component distribution is a business with razor thin margins. Nu Horizons has 15% gross margins and SG&A costs that are 12-14% of revenue, and stated in their FQ107 conference call that a large portion of SG&A costs are based on sales incentives. These costs are incurred only when material is shipped to an end customer. Based on the latest 10Q, 81% of SG&A costs are associated with bonuses, commissions, and salaries – but these costs shouldn’t be incurred when receiving compensation for inventory that isn’t sold.

If this took place, operating margins for Q306, Q406, and Q107 would be significantly enhanced. The P&L statements show this is exactly what has happened.

Vitesse disclosed that $23M of its cash burn since January was due to expanding inventories. Investors that I spoke with assume this was excess inventory built at suppliers – but what if this was inventory bought back from their distribution chain?

Distributors who sold back this material, certainly sold back at a premium in order to cover carrying costs, would realize an excellent one-time gain with no associated SG&A. It would also indicate that the distributor is no longer carrying (and therefore profiting from) excess inventory.

I tried to get Nu Horizon’s perspective on my speculation. As part of a continuing conversation with Paul Durando, Nu Horizons CFO, I sent the following email to the company.

Have you listened to the Vitesse conference call?

They discussed excess shipments to distributors and incentives provided for doing so. They also discussed accelerated cash payments from distributors.

Can you answer the following questions?

1. What percentage of Vitesse resale revenue was made under the 'sell-through' model vs. the 'sell-in' or Point-of-sale model?

2. Can you provide some details on how this activity affected your Q306, Q406, and Q107 operating results and inventories?

3. Are there any risks associated with obsolete inventory as a result of this activity?

I am making the assumption that such activity is very profitable for Nu Horizons.

I have not received a response.

What Risks Exist Now?

• Reduced Operating Margins - Sales incentives have much lower associated SG&A, and therefore flow to operating income with higher margins than the core distribution business. If Nu Horizons was receiving incentives from Vitesse, and those incentives have stopped, their operating margins will contract.
• Reduced Future Margins - If Vitesse has stopped shipping excess inventory into distribution, distributors will have less leverage when renegotiating franchise agreements (resale margins in particular)? Vitesse will no longer be needy in their negotiations, and be forced to grant larger distribution margins in order to secure a distributor willing to take excess inventory. Vitesse is Nu Horizons second largest supplier and a key source of value added distribution income.
• Inventory Risk - Suppliers that aggressively ship into distribution channels typically are facing challenging financial conditions. Once a distributor agrees to accept inventory beyond what it can easily sell, they are no longer a distributor- they are a business partner. Stocking useless inventory exposes a distributor to great risks if the supplier were to become insolvent and incapable of honoring credits and returns.

  From the Nu Horizons FY06 10-K

  For example, at fiscal year end, each additional 1% of obsolete inventory or if the Company was unable to return inventory pursuant to its distributor agreements and could not be returned under our many distributor franchise agreements, would reduce operating income by approximately $1,250,000 for the year ended February 28, 2006.

  Another way to look at this is each additional 1% ($1.3M) of obsolete inventory would reduce operating income $0.07 a share. Nu Horizons earned $0.17 in FQ107, and $0.27 for all of FY06. Vitesse appears to have shipped $16M more product than necessary during two quarters – assuming Nu Horizons was the recipient, how much of this inventory is still fresh and how much could they return?

Summary

History shows that McAfee, Bristol Meyers, Sunbeam and many other companies who accelerated shipments to distributors offered lucrative financial incentives. While my conclusion relies on many assumptions, historical precedent shows Nu Horizons likely benefited from activity that has now ceased according to Vitesse.

Ultimately, it is the responsibility of the Boards of Directors of component companies to investigate the practice of using sell-in rather than sell-through as a means for recognizing revenue. Modern inventory systems have all but eliminated the need to use sell-in as an accounting method.

Xilinx (XLNX) was the largest supplier for Nu Horizons with $104.6M (22% COGS) and Sun Microsystems (SUNW) was third with $75.5M (16%). Vitesse and these three companies accounted for 55% of inventory purchases (calculated as a % of COGS). If Xilinx and Sun Microsystems use sell-in methods similar to those used by Vitesse, these transactions should be investigated by the audit committees of each company.

Disclosure: I hold Vitesse Semiconductor stock and am short Nu Horizons.

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