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The Vitesse (NASDAQ:VTSS) accounting debacle announced yesterday will impact other companies in the components market. My gut feeling is that other non-commodity component companies are engaging in this behavior right now. The old adage applies - if you see one roach, there are a thousand more.

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 (NYSE:AVT) and Arrow Electronics (NYSE: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.

Source: Fallout From The Vitesse Debacle: Distributors Nu Horizons, Avnet and Arrow