Synnex: Thin Profit Margins, Concentrated Ownership

Jul.12.07 | About: SYNNEX Corporation (SNX)

Mid Cap Watch List member Synnex (NYSE:SNX) reported strong earnings just before it was added to the Watch List. It just filed its 10Q, so I decided to take a quick look.

Synnex is a Business Process Outsourcing [BPO] company. Other companies hire Synnex to manage business functions such as distribution, assembly and logistics. Nearly all of the company’s sales are to North American customers. Hewlett Packard products account for 28% of the company’s distribution sales.

The first thing I noticed was a large increase in accounts receivable, which rose more than 50% since November compared to a 9% increase in sales and resulted in negative cash flow from operating activities for the first six months of the year. It turns out the company changed the way it accounts for certain receivables:

The Company has established a revolving securitization arrangement (the “U.S. Arrangement”) through a consolidated wholly-owned subsidiary to sell up to $350,000 U.S. trade accounts receivable based upon eligible trade receivables (“U.S. Receivables”). The U.S. Arrangement expires in February 2011. The Company’s effective borrowing cost under the U.S. Arrangement is a blend of the prevailing dealer commercial paper rate and LIBOR plus 0.55% per annum. Prior to amending the U.S. Arrangement in February 2007, the Company recorded the previous U.S. Arrangement as an off-balance sheet transaction because the Company funded its advances by selling undivided ownership interests in the U.S. Receivables. The amended U.S. Arrangement requires the Company to account for this transaction as an on-balance sheet transaction because the Company funds its borrowings by pledging all of its rights, title and interest in and to the U.S. Receivables as security.

Including more of the receivables on the balance sheet will improve comparability in the future, and earnings will be of higher quality. Still, however, the company’s Canadian division can continue to carry as much as $125 million in receivables off balance sheet. The fact that such a large percentage of receivables was carried off-balance sheet in the past should encourage investors to be especially vigilant when it comes to earnings quality issues.

Synnex operates on thin profit margins (net profit margins are less than 1% of sales). Given the potential for fixed cost leverage, minor increases in revenue could lead to very large earnings gains. However, the leverage also works the other way and the company could quickly experience losses should there be a revenue setback. Revenues are highly dependent on the end-market demand for IT products and services.

During the first six months of the fiscal year Synnex paid total consideration of approximately $115 million to acquire four companies. Despite the fact that this amount represents approximately 18% of the company’s market capitalization, the company claims that “The above acquisitions, individually and in the aggregate, did not meet the conditions of a material business combination and they were not subject to the disclosure requirements of SFAS No. 141, “Business Combinations.” The acquisitions were:

• Link2Support, a technical support and contact center based in the Philippines
• PC Wholesale, an IT distributor focused on refurbished and end-of-life equipment
• China Civilink, a China-based domain registration and web hosting provider
• Redmond Group, a consumer electronics distributor

Synnex also has a complicated relationship with MiTAC International, which owns 46% of the company’s shares. Matthew Miau serves as Chairman for both companies. MiTac is a major supplier to Synnex but supply agreements have been informal and there are no contracts or other assurances the relationship will continue. MiTAC introduced the company to several customers, including Sun Microsystems (NASDAQ:SUNW), with whom the company’s account requires a continued relationship with MiTAC.

Due to the thin profit margins and concentrated ownership, Synnex is not the type of name I would hold for a long-term investment. To me, it seems better suited for trading opportunities when demand for IT products and services is growing rapidly.

SNX 1-yr chart: