Syntax-Brillian: Time to Hit the Snooze Button

In an article I wrote nearly 2 weeks ago, but published on Thanksgiving, I asked whether or not the management of Syntax-Brillian (NASDAQ:BRLC) received the wakeup call the market has been giving them the past several months. My understanding of Syntax-Brillian has been much improved over the last week, as many of my questions have been answered. Based upon what I have learned from the most recent press release and conference call on Wednesday and the shareholders' meeting on Thursday, management appears to be asking investors to hit the snooze button for the next 12-18 months. For reasons I will describe in more detail below, however, the company I thought I knew is not the same company I know today, which in certain respects is both good and bad.

NOTE: This article was written last weekend, and the delay in publishing has been to check facts with various sources. Also, I have addressed a couple issues that have arisen since the article was first written.

Referring to my previous article, I suggested a "7-day action plan" prior to the shareholder meeting on Thursday, November 29, 2007. In describing this action plan, I listed seven items that I wanted to see addressed. The following is a summary of how Syntax-Brillian addressed those issues.

1) Address the Short Issue

During the conference call, the CEO of Syntax-Brillian, James Li, asked shareholder to register their shares in their own name. James Li also stated that the short issue would be addressed through execution. In essence, Syntax-Brillian's approach to the shorts is unchanged. I suspect that many investors are unaware of how to register shares in their own name, and unless the company makes it easy for them, I doubt that many will do so. As such, I believe the shorts reign over Syntax-Brillian's share price will be unchecked.

2) Stock Buyback

Although both James Li and CFO, John Hodgson, bought shares 2 weeks ago, none of the other management team has followed suit. Moreover, there has been no indication that Syntax-Brillian is contemplating a corporate buyback of stock.

3) Address NASDAQ deficiency letter

Again, James Li addressed this issue during the most recent conference call. However, James Li merely repeated a past statement that the company would cure this deficiency by March 31, 2008, which is the deadline.

4) Drop the proposed 60M increase in authorized shares

This proposal passed. However, the proposal to change the name of the company to Olevia International was shelved for 2 weeks to allow for additional voting.

5) Clarify China Strategy

This is one of the most important issues that I saw going into the shareholders meeting, and management certainly clarified this issue to me. Syntax-Brillian will be using a completely separate entity named Olevia Far East (with no ties to Syntax-Brillian or its management) to sell product in Asia. This company will source/finance the product, and Syntax-Brillian will receive a 3% royalty (based upon revenues) for the use of the Olevia brand.

What was also clarified was that despite Syntax-Brillian not financing production of product for China, Syntax-Brillian would not be able to increase their production for rest of the world (i.e., mostly N. America). For sake of clarity, the 550K unit/quarter capacity that Syntax-Brillian has discussed before is production meant for N. America (i.e., excludes China).

6) Clarify current production capacity and capacity into CY2008

My current understanding is that capacity to manufacture product (both for China, N. America, and the rest of the world) is essentially unlimited (i.e., not necessarily limited by the 550K unit/quarter capacity recently announced). Moreover, the current demand, particularly in N. America, far outstrips Syntax-Brillian's ability to supply product. Also, out of the $250M loan that Syntax-Brillian recently received, Syntax-Brillian has about $100M that they have not used.

However, the problem facing Syntax-Brillian's ability to increase sales in N. America is two-fold. First, the panels being used in product that has been shipped to the Chinese market is sourced from plants in China and is not the same quality as panels (e.g., from LG.Philips and Sharp) used to make product from the N. American market. Thus, Syntax-Brillian cannot simply shift production meant for China to production for N. America. The second problem facing Syntax-Brillian is a very tight supply of panels, which management has indicated could last into holiday season of 2008 (loosening up after August/September 2008).

7) Be open with investors and don't stop being open with investors

With the most recent conference call, James Li has taken a step in the right direction. The question remains, however, is how much information investors will receive in the future. Of note, during the last conference call, SCHOT paid down about $20M of account receivable, but it appears that they are still way behind even given a 120 day payment term. It could be that Syntax-Brillian will not be paid for 160-200 days from when product was shipped and recognized as revenues.

Before I address some other issues, I would like to clarify some information based upon information I received during my trip to the shareholder's meeting:

Loan Covenants: On page 111 of the Credit and Guaranty Agreement dated 10/26/07 (filed in the 8-K the same day), there are requirements for Consolidated Adjusted EBITDA and Revenues. Based upon the new model, these numbers will not be met. However, during the shareholders meeting, James Li clarified that the Agreement would be modified and Syntax-Brillian would not be in default of the loan.

Tooling Deposits: Each LCD TV has about 4-5 molds per set, and each mold can produce between 80-120K units. Management is aware that the "tooling deposits" could be better characterized on the balance sheet. As such, these tooling deposits may be subsequently reclassified on the balance sheet as Property and Equipment and amortized over the life of the tools. Significantly, for investors valuing the Net Tangible Value of the company, Tool Deposits ($123M as of 9/30/07) probably should not be given any value since the molds to not have any use outside of making plastic shells for Olevia LCD TVs.

Lawsuits: Currently, Kolin is in negotiations with Sony and Syntax-Brillian is being sued by Funai and facing a shareholder's suit. I am comfortable that none of these suits will have any material impact on Syntax-Brillian.

Acquisition: In my prior article, I indicated the possibility of Syntax-Brillian being acquired. At the time, my main concern was that Syntax-Brillian did not have enough financing available to grow the business to its fullest. However, it appears that financing is no longer the problem. Instead, the panel shortage is the problem. Based upon the new revenue/royalty model and the panel shortages, I believe that Syntax-Brillian would be a much less attractive acquisition target than I indicated in my first article. Although a merger/acquisition could still be in the works, the more likely candidate would originate from Asia and not the U.S. However, management appears to be comfortable proceeding on their own for now.

As an aside, several articles (written by shorts) have been published that discuss Vizio as competition with Syntax-Brillian. However, as evidenced during a recent conference call, James Li does not consider Vizio to be a "competitor." The CEO's have ties that go back to Gateway Computer (aka Gateway 2000) in the 90s. Given Vizio's apparent desire to have access to the US capital market, the possibility of a merger between the two companies should not be discounted. If such an event were to occur, I would be very interested to see how the shorts would spin it after lauding Vizio and bashing Syntax-Brillian.

As can be seen from the rough estimates above, the change from the old model to the new model (i.e., the royalty plan) has a drastic impact on the EPS numbers. The difference in gross margins reflects statements by management that margins in China are 3 to 4 points higher than elsewhere.

My understanding is that BRLC's lenders and certain of BRLC's institutional holders drove this change to a royalty model for product sold in China. The reason why the bankers pushed for this change is fairly obvious. The $250M loan is secured by Syntax-Brillian's assets, which for a company that does not have any significant manufacturing assets, means that most of these assets will be held in accounts receivable (AR). From the banker's perspective, it is far easier to evaluate the risk of non-collection on AR to companies such as Target, Sears, Circuit City, and Best Buy than it is to evaluate the risk of non-collection on AR to SCHOT. During the shareholder meeting, James Li specifically stated that the lenders/institutional investors were not giving any credit to the Chinese revenues/earnings (a phrase he used at the time was "quality of earnings").

However, as evidenced by the EPS projections given above, this change, while being in the best interest of the bankers, in my opinion, is not in the best interest of Syntax-Brillian's shareholders. During the summer (if not earlier), I speculate that management of Syntax-Brillian believed that they could not fulfill their orders to N. American clients with the operating capital they had on hand. At that time, I believe the decision to change Syntax-Brillian's operating model was made.

In fact, management made comments during the summer as to the possibility of a Chinese subsidiary that would take over the AR from SCHOT and this AR would be able to be financed in Asia. In my mind, this model would have been much more preferable to the royalty model since the royalty model gives up a substantial portion of the gross margins generated in China but does not proportionally reduce other expenses. As such, with the new model and considering the write-offs based upon the LCoS divestiture, Syntax-Brillian will likely have a negative EPS for FY2008 after have a positive $0.48 EPS for FY2007. Based upon further research, however, Syntax-Brillian could not employ this strategy (i.e., factor receivables from Chinese banks) without either having 3 years of public financials or buying a Chinese company that had 3 years of published financials.

Many longs, including myself, did not understand why the shorts continued to plague the company throughout the spring and summer, even after Syntax-Brillian raised its guidance to $1.1B-$1.3B in revenue for CY2007 during mid-July (which combined with Syntax-Brillian's cost structure, led many investors and analysts to expect an EPS for FY2008 to be above $1.00/share). We kept asking the question: "what do the shorts know that we don't?" What the shorts knew, probably leaked by one of the lenders or institutions that bought during the secondary in May was that Syntax-Brillian was going to be changing their revenue model, and this change would significantly decrease future EPS.

Problems Facing Current Investors

Although Syntax-Brillian is embarking on a path that will make its operations more transparent to the market and there does not appear to be any credibility to past rumors that Syntax-Brillian has engaged in shady accounting practices, Syntax-Brillian investors are not out of the woods yet.

The first problem facing Syntax-Brillian investors will be horrendous year-over-year comparisons for the next several quarters, at least until Q3 or Q4 of 2008. For FY2007 (ending 6/30/07), Syntax-Brillian had $698M in revenues, net income of $30M, and an EPS of $0.48. Not counting the charges for the divestiture of LCoS, for FY2008 (ending 6/30/08), Syntax-Brillian (given high-end of guidance) is looking at $636 total revenues ($685M US revenues and $18.5M in China royalties), net income of $16.7M, and an EPS of $0.17 (assuming 100M shares). As such, these numbers show decreases in both revenues and earnings. Moreover, even assuming a very conservative 5M increase in share count, Syntax-Brillian's share count for FY2008 will increase substantially over the share count for FY2007. Declining revenues, declining margins, declining earnings, and an increase in share count will not likely garner Syntax-Brillian a high valuation by the market. Even a solid PE ratio of 15 only yields a stock price of $2.55/share.

Another comparison is Q4 of CY2006 to Q4 of CY2007 (i.e., the current quarter). Again, not counting likely charges for the divestiture of LCoS, best-case guidance from BRLC yields an EPS of $0.03 for Q4 of CY2007. By contrast, Q4 of CY2006 came in with an EPS of $0.24.

With Syntax-Brillian's current margins and cost-structure, it will be very difficult for them to even approach the EPS number posted for FY2007 in either FY2008 or FY2009. It is impossible to know whether or not Syntax-Brillian will tap into the 180M shares now authorized. However, since Syntax-Brillian brought the increase in share count from 120M to 180M during the current shareholder meeting, one can only assume that Syntax-Brillian believes there is an opportunity to reach at least the 120M mark sometime before the next shareholder's meeting 12 months from now. If so, the increase in share count will only make achieving the EPS numbers even harder.

Currently, consensus estimates for CY2008 are $815M in revenues and an EPS of $0.40. However, these estimates have not been updated since the new revenue model has been updated. As such, as analysts' estimates continue to drop, I believe the sentiment of investors, already at an all-time low, will continue to get worse.

A second issue facing Syntax-Brillian and its investors the next 12-18 months is the panel shortage. Syntax-Brillian (like many LCD TV manufacturers) does not make their own LCD panels and must buy panels from manufacturers such as LG.Philips and Sharp (among others). Traditionally, Syntax-Brillian signs a contract with LG.Philips sometime after CES (held every January in Las Vegas). However, unlike recent years, in which the panel manufacturers were struggling as a result of a panel glut (i.e., overcapacity) and a reduction in panel prices, the current panel shortage, which Syntax-Brillian management has indicated could go into late 2008 or even 2009, could have a serious impact on Syntax-Brillian's ability to grow.

Syntax-Brillian is not the only manufacturer buying panels from these panel manufacturers. To grow business in N. American and beyond in 2008/2009, Syntax-Brillian needs to (i) substantially increase the number of panels they will receive and (ii) obtain these panels at a reasonable price. Since an LCD panel is around 60% of the total cost to manufacture an LCD TV, an increase in panel costs will lead to decreased margins. The risk to Syntax-Brillian is that other LCD TV manufacturers will cut into Syntax-Brillian's supply and/or raise the Syntax-Brillian's costs by engaging in a bidding war for the panels. Whether or not Syntax-Brillian is able to secure increased numbers of panels and at reasonable prices is may be the most important factor an investor should focus on in the coming months. Although time will tell whether or not Syntax-Brillian faces a similar situation, Vizio is currently in the cross-hairs of the Japanese manufacturers because of Vizio's disruptive pricing.

Another issue that could arise in the next 3-12 months is how long John Hodgson stays as CFO. Given his past work history, John Hodgson may only be the CFO temporarily. If he were to leave, and if he were to do so in a manner in which the market received sufficient notice, then it should not be a problem. However, if Mr. Hodgson was to leave in a manner similar to how his predecessor (Wayne Pratt) left, then the market will not likely treat such a departure positively.

In conclusion, Syntax-Brillian is a changed company and past analysis of the company and its value are no longer valid. Although Syntax-Brillian will be more transparent and less dependent upon uncertainties arising from doing business in China, Syntax-Brillian's margins and cost structure can no longer support the share price Syntax-Brillian's investors saw 12 months ago. Also, it may be 12-18 months before investors again see share prices of just 1 month ago, and several years before investors again see share prices of just 45 days ago.

I have found predicting the share price of BRLC to be a difficult, if not impossible, endeavor, but that still does not prevent me from trying. If Syntax-Brillian's share price follows the underlying fundamentals, then current shareholders face a greater downside risk than upside potential. Personally, I would not be a buyer of shares in BRLC over $2/share. Moreover, I would need some type of assurances that Syntax-Brillian's future supply of panels is not in any jeopardy before taking a long position. My advice to investors wanting to get into Syntax-Brillian is wait for a better deal and then hit the snooze button for about 16 months.

Disclosure: The author has extensively commented on BRLC under the pseudonym "traveler20202" for over 2 years. Currently, "traveler" is a moderator for a message board dedicated to discussions about Syntax-Brillian. The author has no position in BRLC.

Comments

[Arohan:]

I like your analysis and I will have to check out your model for eps calculations. My one comment would be with half of the sales now outsourced and on royalty model, the SG&A should go down. The reduction you show in SG&A of 15m appears to be the LCoS disposition. Best case, if it is cut in half, than that would add about 0.4 to the EPS. There are a few other things that I think are the wildcards in here

a. Syntax-Brillian's ability to raise prices; migration towards tier 1 designation
b. Sales in Europe and Latin America, specially with Vivitar channel in 2008
c. Any jump in sales due to Olympics in China in 2008, and
d. Reinvestment of SCHOT AR when paid into additional capacity (some of the panel shortage issues can be mitigated if BRLC is able to raise prices and can afford to pay a bit more for panels)

arohanvalue.blogspot.c...

2007 Dec 06 12:49 PM

[Arohan:]

Something else that doesn't make sense

This is a company that is selling today for less than net tangible assets, is profitable and based on current price of 2.7, the earnings yield at your estimated eps of 0.17, is 6.3%. So here we have almost a risk free investment, offering an yield of much greater than any risk free instrument you can find in the market, and we are looking at interest rate reductions. Also, your assumptions are very very conservative and excludes many things including the SG&A reduction that I pointed out earlier.

Additionally, the gross margins will improve in 2008 after this temporary blip.

This looks like a no-brainer investment right now

2007 Dec 06 01:00 PM

[Steve Smith:]

Net tangible assets, as it is currently calculated, includes $123M in tooling deposits ... this isn't cash that BRLC can retrieve at any time ... this money has already been invested in tooling. Basically, one way to look at it is that tooling deposits are pre-paid cost of goods sold.

Anyway, hypothetically, if BRLC was to be liquidated (another way of describing net tangible assets is liquidation value) these tooling deposits would have no real-word value. As such, I believe to consider these tooling deposits as part of the net tangible value is a mistake.

As such, I believe the true net tangible value is nearly half of what many people think it is.

2007 Dec 06 04:38 PM

[Steve Smith:]

Most of the LCOS savings comes from the gross margins .... last quarter they had -3.3M in gross earnings from LCOS ... as such, not much will come from SG&A. Also, SCHOT already did all the marketing and distribution work for BRLC ... thus, not much savings in SG&A costs there .... when it is all done, you could expect around $5M savings/quarter ... and my SG&A numbers reflect $20M for Q1/Q2 and $15M for Q3/Q4.

My numbers reflect BRLC's most recent revenue guidance for FY2008 ... if you think that the revenue numbers are light, take it up with them.

As for China, you don't think that BRLC isn't aware of the China Olympics and have already adjusted their guidance accordingly?

Capacity is not a problem (period) ... I have this on very high authority .... getting sufficient panels is the problem ... until the panel crouch ends, BRLC's growth will be constrained.

Remember, BRLC isn't the only one buying panels .... however, BRLC is probably one of the most cash-constrained companies buying panels .... you think that some of the tier-1s would be willing to pay a higher price to prevent BRLC from getting a sufficient supply to prevent BRLC's disruptive pricing? Personally, I have no idea whether this is possible or not ... however, it is a risk factor.

2007 Dec 06 04:30 PM

[BRLC_LongTI...:]

Your EPS is way off. Royalty income should be getting added directly to bottom line.
For new model, by fair calculations EPS for 2008 will be close to Old model. with half of the interest expense & half of Loan liability.
BRLC is worth more than what it was prior to China Royalty news. This will be reflected in pps, soon.
Watch & learn.

2007 Dec 06 07:58 PM

[Steve Smith:]

"Royalty income should be getting added directly to bottom line." Based upon this comment alone ... it is readily apparent that you don't understand some basic financial concepts. Royalty income is simply revenues with 100% margins. More important, royalty income is taxable, which means is doesn't get added directly to the bottom line.

My suggestion to you is to stick with index funds .... if you cannot figure out an income statement, then you should be staying away from individual stocks.

2007 Dec 07 03:39 PM

[Arohan:]

1. Most of the LCoS expense was R&D with LCoS accounting for a substantial number of BRLC employees that were let go. I would not discount it

2. If BRLC would be sold today, the mold for Olevias would be useful to the acquirer an hence the 'tooling deposits' would not be worthless

3. Tier 1s and other lcd manufacturers run at even smaller margins than BRLC. Why do you think they can more afford to pay up for the panels than BRLC? It is also difficult for a buyer (like Sony, for example) to manipulate prices in a supply constrained situation (if you are thinking they will voluntarily pay more to ensure that BRLC is put out of business). Your arguments here do not hold water

2007 Dec 07 02:30 AM

[Steve Smith:]

1. R&D is currently less than 1% of revenues ... during the last CC, James said that R&D would be headed to 3% of revenues ... which means that whatever savings are realized from the divesting of LCOS will be lost because of an increased R&D budget.

2. You apparently don't understand "net tangible value" and the underlying assumptions. Net tangible value is the value of a company !!not!! as a going concern. Thus, you discount any "intangible value." Your valuing of the molds assumes the company will continue to product product with the molds ... which means you aren't valuing the company for net tangible value ... instead you are valuing the company as a going concern. Unless somebody is going to be making Olevia TVs, then the molds are essentially worthless.

3. I have no idea where you got the crazy idea that Tier-1s have lower margins than BRLC. For example, BRLC buys panels (which are the vast majority of the cost of making a LCD TV) from LG.philips. A 32" LG TV (who presumably also buys panels from LG.philips) sells for $850 at Circuity city, whereas a 32" Olevia TV sells for $550. Are you telling me that Syntax-Brillian has higher margins than LG on this product????

Tier 1 manufacturer, by virtual of being a Tier-1 manufacturer, can demand higher prices/margins. To say that BRLC has higher margins than these companies is to commit a grave error in your analysis.

If you looking at the percentage of SG&A costs, as a percentage of Revenue, you'll see that Sony has higher much higher SG&A costs than BRLC's margins. Thus, for Sony to even break even, they have to have higher margins thatn BRLC.

2007 Dec 07 03:51 PM

[Arohan:]

"Thus, for Sony to even break even, they have to have higher margins thatn BRLC."

Steve, I wished I understood what you mean by the statement above. May be you can research the comparative profitability in this industry to get an idea of what everyone's profit margins are

By the way, as for your point 1 above, I was contending that LCoS accounted for a substantial number of BRLC employees, that have been let go. This will reduce SG&A significantly. I guess you do not see it this way. We will just have to wait for the next quarterly report to prove you wrong

Also for a little perspective, 1% of revenues for BRLC amounts to 7 cents eps. So don't be so dismissive. You may have made many assumptions that you think are insignificant but they have profound impact on the final eps number. As such, your eps estimate has a very large margin of error and cannot be used for any basis for investment

Your point number 2 does not clarify or reject what I said and there is nothing for me to add

Good luck
arohanvalue.blogspot.c...

2007 Dec 07 10:30 PM

[Steve Smith:]

If Sony's SG&A expenses are approximately 25% ... thus Sony (for all their products, on average) needs margins of 25% to cover SG&A. Of course, Sony is a company that has lots of different products and business units so not all products needs to make 25%, but what it does indicate is that the average Sony product needs to make at least 25% to cover SG&A expenses.

As for SG&A expenses ... I asked what was going to be saved on SG&A, and the answer I got was about $5-6M ... as I have noted in some of my posts, I calculated SG&A of $20M for Q1/Q2 and $15M for Q3/Q4. I kept Q2 as a high number because not everything had been finalized and Q2 is the biggest quarter in terms of sales so that marketing/advertising is probably higher than average.

"Also for a little perspective, 1% of revenues for BRLC amounts to 7 cents eps" .... wrong. You forgot both taxes and you margins ... 1% of revenue amounts to $0.0065 (i.e., less than 1 cent) of EPS. Moreover, you don't know how much extra it takes in SG&A expenses to get that extra 1% of revenues or how that it will effect margins.

FYI, I used managements top-end guidance with my estimates as to revenues. Regardless, even if you add $0.10/share

As for point 2 ... people are saying that the lower end of BRLC's stock price is the net tangible value ... my point is that don't be fooled into thinking that BRLC's breakup value is higher than what it actually is.

2007 Dec 07 11:10 PM

[User 128635:]

I cant believe there would be much interest in this company after the management there lied about their future guidance. There are hundreds of wonderful companies to invest in. Syntax-Brillian is close to being a nest of crooks! BRLC make Angelo Mozilo at Countrywide Financial look like an altar boy.

Stay away from this one!!

2007 Dec 07 10:25 PM

[HarMegiddo:]

another shame is that Steve has to rebut all these dullards who obviously own the stock and have probably lost their behind in it.

2007 Dec 07 11:38 PM

[Huskymaniacny:]

Actually, no, Steve does not need to rebut anyone. Even if he was holding shares of BRLC he wouldn't HAVE to rebut them. And, yet, he clearly seems compelled to do so. Why? Either he is a wolf in sheep's clothing or he has an axe to grind because he lost HIS behind on BRLC. Actually, what is more likely is that he saw his paper gains evaporate in front of his eyes and he is very bitter.

If you think about it, why would anyone that isn't long or short in a company bother to do such an analysis and, even if they don't have anything better to do, why bother publishing it? Forgive me for being skeptical but I doubt he is the Mother Theresa of the investment world.

2007 Dec 08 09:41 AM