Syntax-Brillian: A Classic Bottom

The current share price for Syntax-Brillian (BRLC) of $2.52 reflects investor panic and not the economic value of its growing worldwide brand (Olevia).

For growing businesses, valuations like these (see below- .28X revenue-5X earnings) arise when investors have given up on the company. Observe the large discount to relative fair value (see below - $5.77 per share). This is a classic bottom scenario. Heavy tax loss selling, and crowded short positions in a stock under $5, make good candidates for a January bounce.

The current environment actually favors BRLC (Olevia) over other TV manufacturers. BRLC has increased prices 3 times in the last 90 days, and has excellent relationships with panel manufacturers to ensure a steady price-protected supply of panels. Additionally, they have numerous consumer report best in class accolades. These are not insignificant awards. They compete with the likes of Sony (SNE) and Samsung.

Rounding BRLC's capitalization to 100 million shares (presently 93,350,000), my calendar year 2008 model would look something like this:

• Total revenue: $850,000,000
• Royalties (3% of $500,000,000): 15,000,000
• Gross profit (15% of $850,000,000): 142,500,000
• SG&A: 42,500,000
• R&D: 4,200,000
• Non-cash (added back): 4,000,000
• EBITA: 99,800,000
• Operating profit (subtract non-cash): 95,800,000
• Interest:18,000,000
• Taxes: 29,300,000
• EPS: .48

We arrived at a $7.20 target price based on 15 times earnings. This revenue estimate does not include Europe, Latin America, or any other licensing opportunity for the Olevia brand.

The original investment thesis put forth on BRLC was a momentum based revenue model. With hindsight, this model could not finance its growth due to the fact that Chinese receivables were not collectable for 120 days. Shareholders were not willing to live with the negative cash flow, so a model change was inevitable. If there is any question about why BRLC did not factor their receivables, the answer is that they tried and failed. Chinese banks require a 5 year operating history, and $100 million trailing EBITA. Domestic and European banks would only lend against accounts receivable. They would not purchase them. The royalty model was the best alternative.

BRLC's new model eliminates Chinese revenue and its 6 1/2% net margins, and replaces those profits with a 3% royalty. This trade off is beneficial because it eliminates the South China House of Technology's [SCHOT] 120 days sales outstanding [DSO]. Going forward with normalized DSO's in the 45-50 day range, we should see positive cash flow by June.

In our opinion, the main reason BRLC stock price has underperformed is because of the 120 day SCHOT DSOs. With the balance sheet being stressed and concerns about SCHOT not performing, doubt and fear in the minds of investors was the result. Financing its growth by issuing more stock delayed the inevitable, hence the new model. Now BRLC gets paid first rather than last. The China DSOs go to zero.

SCHOT receivables were approximately $92 million at the end of September. Recent insider buying by management and current board members is evidence that these receivables are money good. Currently Chinese retailers like Broadway and Gome hold yuan currency longer due to the depreciation of the US dollar. By keeping their currency longer they earn more. This does not mean that these receivables are noncollectable. Last spring SCHOT's receivables were higher than today's and longer than 120 days. All were collected. BRLC's auditors have given no indication that these would result in noncollectable accounts receivable.

Many on Wall Street complain about the loss of revenue and profit margin on the Chinese sales. This is short-sighted. The Olevia brand continues to gain traction worldwide with the dual revenue strategies. No one gives them any credit for brand value creation. If you sell 500,000 units under the new model in China with the royalty method versus the revenue method, you are still creating value for the brand. Even with a reduced margin this should not be discounted. Consumer product companies place a premium value on brand awareness. This is a significant milestone for BRLC because the Olevia brand has meaningful value. If the public marketplace does not award BRLC an appropriate value then private equity investors maybe the answer. The BRLC board could also explore other alternatives by hiring an investment bank. Remember management and the board hold large equity stakes, over 20% and growing. Recent rumors about Vizio and others make evident that this company has a fair market value much higher than today's $2.52 price.

Given BRLC's history of sustained plus growth (over 200% in 2007), we have concluded that the market has irrationally focused on accounting rather than economics and brand creation. This has led us to an outstanding franchise at a very attractive price.

According to Collins Stewart, BRLC has a book value as of September 30, 2007 of $5.57. Thus with the stock at $2.52 investors are buying BRLC at 45% of book value, and getting the ongoing franchise for free.

We continue to estimate BRLC's normal earning power between $0.45-$0.55 per share for CY2008 and $0.60-$0.70 for CY2009. This assumes 50% growth in North American sales YOY. Royalty income from Olevia China and other branded Olevia products (DVRs) should contribute $20-$25 million annually. European and Latin American sales are the wild cards which could easily cause our numbers to be low.

Look for the new year to bring in a fresh perspective regarding BRLC. It is trading at 5X earnings, .28X revenues, and 45% of book. With a new business model that should deliver accounting transparency and positive cash flow, it should be obvious to investors that the last days of 2007 was a classic bottom.

Disclosure: The author has a long position in BRLC.

Comments

[Joseph Terry]

Your analysis, while detailed, falls down in several respects.

In November, Syntax-Brillian provided estimates for FY2008 (ending June 30, 2008) including Vivitar global sales and excluding sales made through the royalty program of $650M-$685M. Based upon FY2008 Q1 revenue numbers ($150M) and estimated revenues for the current quarter ($155-$165), this means that Syntax-Brillian is estimating revenues for the 1st half of CY2008 to be $345M-$370M. This means that your estimates for the 2nd half CY2008 is that BRLC will have $500M in revenues. Although this number isn't unreachable, it is very optimistic and not based upon guidance provided by Syntax-Brillian.

Your estimates for SG&A expenses are VERY optimistic. For the last 4 quarters, Syntax-Brillian's SG&A expenses were $66M. By comparison, you are estimating SG&A costs for the next 4 quarters to be $42.5M. Although Syntax-Brillian will realize some reduction in SG&A expenses from the elimination of the LCoS unit and China sales, these reductions will not be as great as you apparently believe. SCHOT handled all the sales/marketing work for the China sales. As such, Syntax-Brillian will gain very little, in terms of SG&A, based upon the new royalty model. Regarding LCoS, one could expect perhaps $10M/year savings for that unit, which added to, at best, a $5M/year savings for China, gets a savings of $15M/year. However, the $66M in SG&A expenses for Syntax-Brillian's last 4 quarters doesn't recognize that BRLC was at a $76M/year pace the last 2 quarters. If Syntax-Brillian is to maintain the Olevia brand and if U.S. sales are to continue to increase, they will need to continue their marketing campaign in the U.S., which further increase SG&A numbers. I think you are grossly unrealistic to believe SG&A expenses are going to drop to less $11M/quarter. If Syntax-Brillian achieves the revenue growth you are expecting for CY2008, the SG&A numbers are likely to be double what you anticipate.

Regarding R&D, your numbers are pegging R&D at 0.5% of revenues. However, in November, Syntax-Brillian announced the goal of getting R&D to 3.0% of revenues. As such, your estimated R&D expenses are, again, unrealistic. Put another way, BRLC's increased R&D expenditures all but gobbles up the royalty stream from China.

Working with SG&A numbers of $85M and a R&D budget of 2%, while using your optimistic revenue and margin numbers, your EPS number goes from $0.48/share to $0.16/share. Knock revenues and margins down just a little bit, and BRLC will struggle to break even in CY2008.

BTW: You need to explain your "Non-cash (added back)" a bit more clearly.

Your statement that "BRLC's new model eliminates Chinese revenue and its 6 1/2% net margins, and replaces those profits with a 3% royalty." is EXTREMELY misleading and is comparing apples to oranges. Assuming a $100M/quarter of revenues from China, the royalty model drops $3M to taxable income. By comparison, the old model conservatively drops $16M ($20M gross profit - $2M expenses - $2M interest) to taxable income. This is one of the biggest reasons why Wall Street is down on the company. Assuming $500M/year in China revenues, the new royalty model drops $15M to taxable income whereas the old model would have conservatively dropped $80M to taxable income.

Regarding the Chinese royalty model, what I find interesting is that many current longs expect a company with little history (i.e., "Olevia Far East), which will be the distributor in China and from whom Syntax-Brillian will receive the royalty payments, to be able to finance all the Chinese growth without any problems.

Another of the other reasons that Wall Street is down on Syntax-Brillian, is the very low EPS estimates going forward. Current consensus analyst estimates for FY2009 are $0.26/share. 30 days ago that number was $0.51/share. 60 days ago, that number was $0.92/share. 90 days ago, that number was $1.26/share.

There is a good reason why Syntax-Brillian's stock price is down at the levels where it is at. Just 4 months ago, management presented a business model that many expected (based upon this model and management's revenues estimates) to produce an EPS of $1/share for FY2008. After the change to the royalty model, the estimated number for FY2008 now sits at $-0.09/share.

[Arohan]

Great level headed analysis! The doom and gloom around the stock is amazing, and as value investors, this is an opportunity that rarely comes by. We are buyers at this level

I have also written more on Syntax-Brillian at arohanvalue.blogspot.c...

[RC Martin]

Joseph,

A good exchange, let's focus for one minute on the expense issue you raised. You suggest a $10MM annual savings AT BEST. An excerpt from the corporate press release follows:
"According to James Li, President and Chief Executive Officer, the decision is expected to result in a one-time non-cash charge of up to $40 million, and a reduction in operating expenses of approximately $16 million annually." You've missed by a WIDE margin.

Further more, the royalty model figures you provide are skewed terribly. On a $100MM sales the royalty will drop $3MM to the bottom line. Previously NET MARGINS were 4% or $4MM per $100MM of sales. So to apply your figure of $500MM the difference is not nearly as dramatic as you wish to have it appear, $15MM for the royalty vs $20MM for the sales method.

Now of course since the royalty method requires no capital risk and frees $400MM of capital to applications of growth elsewhere it seems a small sacrifice for the potential to capture yet another $$20MM of profits via the redirection of capital. Net net it would appear in fact to benefit to the tune of an additional $15MM of profits not the dramatic loss you portray.

[Joseph Terry]

James Li's comments notwithstanding, he wasn't clear whether those operating expenses were savings due to no longer having negative margins due to LCOS and/or savings due to SG&A expenses. My read is that the $16M annual savings is from both.

Regarding the old model versus the new model you are both comparing apples to oranges and is based upon bad assumptions. Net margins is AFTER taxes. In case you don't realize this, the $15M in royalties (based upon $500M in revenues) would be taxed, which takes that $15M down to $9M. Also, your calculations assume that an equal share of the SG&A expenses is attributable to China sales as it is to US sales. This is just plain wrong. All of the sales/marketing for China was previous done by SCHOT. As such, those costs were already wrapped up into the gross margins that BRLC got from the China sales.

BRLC has to work much harder (and spend much more in SG&A) to sell in the US than in China. The margins from China are much better because the lack of rebate programs in China that are common in the US. This is why the China royalty deal is so bad for BRLC. BRLC loses the sales with the best margins but doesn't proportionately reduce SG&A expenses.

I don't disagree that the royalty plan will free up capital, yet BRLC's guidance for the 2H of FY2008 shows how much that doesn't help. BRLC did $368M in revenues in 2H of FY2007, yet they are only estimating $345M-$370M in revenues for 2H of FY2008. What is even more troublesome is that, in the last 12 months, BRLC was able to get a $250M financing deal as well as raise $190M in cash in four offerings (3 private and 1 public) and despite the availability of all these new funds they are only predicting about $180M/quarter for the next two quarters.

Just using the amount of working capital BRLC has been able to obtain in the last 12 months and assuming that BRLC is above to turn the working capital over just 1-time/quarter, BRLC should have capacity to have 1.7B in sales over a 12 month period (4x($250M+$190M)). The fact that Syntax-Brillian estimates (and even your estimates) are considerably lower than that number indicates, to me, that BRLC's growth is being squeezed.

At the end of CY2006, there was about $70M in shareholder equity. Since then, BRLC has had positive earnings and added $190M in cash from sales of stock. Combine all this with the $250M line of credit, and BRLC only thinks they can do about $180M/quarter over the next two quarters? There is something seriously wrong here, besides access to working capital, that is curtailing Syntax-Brillian's growth.

[RC Martin]

Joseph-
Speaking of apples and oranges, could you add some clarity to this:

"At the end of CY2006, there was about $70M in shareholder equity. Since then, BRLC has had positive earnings and added $190M in cash from sales of stock. Combine all this with the $250M line of credit, and BRLC only thinks they can do about $180M/quarter over the next two quarters?"

I'm missing entirely what the equity at the end of 2006 has to do with sales for the next several quarters.

As for growth getting squeezed its not too difficult to understand. If you have sales of 100 and add an additional 100 you've grown at 100%. Now with 200 sales and an additional 100 growth has been SQUEEZED

[RC Martin]

Joseph, sorry the tech gremlin posted before I was finished.
Now with 200 sales an additional 100 sales results in growth being SQUEEZED down to 50% and at 300 each 100 additional squeezes it to 33% growth.

Also you say, "James Li's comments notwithstanding, he wasn't clear whether those operating expenses were savings due to no longer having negative margins due to LCOS and/or savings due to SG&A expenses."

Wouldn't the negative margins been caused by expenses, SG&A being greater than sales? What would have caused negative margins if not expenses?

[Ezzyme]

And I was wondering about those three price increases, what with everyone else cutting prices, aren't they hindering sales?

[Joseph Terry]

Equity, as you know, is simply Assets-Liabilities. For a company with very little fixed assets, its relevance is that it gives some indication as how much working capital (beyond a line of credit) is available based upon the value of the company.

You missed my point about growth getting squeezed. We all know that it is harder to grow the same percentage as the base line number gets bigger and bigger. My point was that BRLC isn't showing the type of growth that the working capital available to BRLC makes possible -- not by a long shot.

Negative margins results from sales (i.e., revenues) being greater than costs of sales (i.e., COGS). To be clear, COGS includes both external costs (e.g., the cost of a panel) and internal costs (i.e., the salaries of people making the product). Last quarter there were $0.7M in LCoS revenues, the cost of those revenues were $4.0M, which resulted in $-3.3M in gross profit. The question over whether to characterize a particular expense as a cost of sale (which affects both margins and gross profit or as an SG&A expense (which doesn't affect margins and gross profit) is constantly being asked by accountants in every company. In the end, it doesn't effect net margins, but it is a cosmetic difference that could change how a company is evaluated.

Over 4 quarters, the resulting savings from divesting the LCoS unit, based upon better margins, is 4 x $3.3M or $13.2M. As such, it is possible that most of the expenses that were associated with LCoS were considered part of COGS instead of SG&A. Therefore, the savings to SG&A, based upon the sale of the LCoS unit, could be minimal.

[RC Martin]

Joseph,
Forget apples and oranges, you've delivered a full basket of fruit this time.Best stop now before you reveal just how little you DO understand.

Equity tells us about working capital? Could you cover that one more time I missed something. I was always trained that working capital was current assets less current liabilities. How did equity join the recipe?

You stated, "Negative margins results from sales (i.e., revenues) being greater than costs of sales (i.e., COGS)." HUH? Once again I missed something or maybe I skipped class the day that concept was taught. If revenues were larger than the cost of goods sold wouldn't you be measuring GROSS profits?

as for that "cosmetic" difference could you provide an example of that and how that effects valuations? That is an interesting concept in itself. So to be clear, if the expense is part of cost of goods sold rather than SG&A it means you have to assign different values to the firm?

[Joseph Terry]

"I was always trained that working capital was current assets less current liabilities." This was the point I was trying to make without getting into the nitty-gritty. I'll concede the point that I should have used current liability and current assets to be clearer. The point still remains that BRLC is vastly underutilizing its working capital. As of the 09-30-07 quarter, Syntax-Brillian has $498M in current assets and $222M in current liabilities or potential working capital of $376M. Again, I'll repeat my point is that BRLC isn't generating nowhere the amount of revenues that could be generated based upon BRLC's working capital.

"You stated, 'Negative margins results from sales (i.e., revenues) being greater than costs of sales (i.e., COGS).' HUH? Once again I missed something or maybe I skipped class the day that concept was taught. If revenues were larger than the cost of goods sold wouldn't you be measuring GROSS profits?"

You are again correct, I should have written COGS being greater than sales. This is what happens when I don't take the time to review what I write very carefully.

However, the end result is still the same. Actually, I did some double checking on my numbers (page 14 of latest 10-Q) and it appears that the COGS for Q1 was $5.0M and not $4.0M, as I initially thought. This means that negative gross profit for LCOS was $4.3M (or $17.2M annually). This would account for all of the savings attributable to the divesting of the LCoS division. Page 14 of the 10-Q includes a little discussion about what goes into "Selling, Distribution, and Marketing Expenses" and "General and Administrative Expenses." Only expenses related to LCD HDTVs and Vivitar were discussed. As such, based upon the information that Syntax-Brillian has provided, it does not look like the new Chinese royalty model or the divesting of LCoS will materially help BRLC SG&A costs, which were $21.1M last quarter, which is considerably higher than your estimated $10.6M/quarter for CY2008.

For someone valuing BRLC, particularly since it is working with low margins, having a good handle on SG&A expenses is critical. If you underestimate SG&A expenses (which I believe you are to a very large degree), you will overvalue the company.

As far as the "cosmetic" difference that could effect valuation, it is quite simple. Shifting an expense that is best counted as COGS to SG&A will increase margins. The general belief is that COGS (as a percentage of revenue) will likely remain steady as volume increases. However, there is a greater chance that SG&A expenses (as a percentage of revenues) will decrease at a greater rate than COGS because SG&A expenses are considered more fixed whereas COGS are considered variable. You have to note that these statements are generalizations and not absolutes. Anyway, the general expectation is that with higher margins, a particular company can become more profitable with increased revenues than a similarly situated company with lower margins.

This is why expenses are broken up between COGS and other expenses (such as SG&A and R&D). In the end, all these expenses are equally subtracted from revenues to obtain net profits, which is the most important number. However, being able to distinguish a COGS expenses from a more fixed expenses can help someone better analyze the operations of the company.

[RC Martin]

Joseph, Thank you for correcting all of those errors in your earlier posts......

I guess what you were trying to say is that COGS is a variable expense and SG&A typically a fixed level of expense such that for each additional unit of production net margins would increase, is this correct?

[Joseph Terry]

Yes ... that is the general perception. However, this point is moot as to the overall picture regarding BRLC.

Personally, I think your revenue numbers and margin numbers are optimistic, but I'm not going to quibble over them.

However, I think your SG&A and R&D numbers are way too low ... probably 50% too low, which makes a huge difference in your EPS numbers.

Also, I disagree with how you characterized the difference between the new model and the old model. In the past, the Chinese revenues accounted for more than half of gross profits and required very little in terms of SG&A expenses. Under the new model, however, monies being received from China will barely cover the proposed R&D expenses. To me, that is HUGE and an investor need only look at what the stock price has done since this new royalty model was announced in early November to see what the market thinks of it.

[Loren Paz]

As far as the new model China model goes there is no doubt that it is much less profitable then directly selling like previously. However, the 120 day terms and late payments in China resulted in cash flow problems. In sort, under the new model, the income statements would be much uglier but the statement of cash flows should be much improved. It might be possible for the company to actually generate postive cash flows from operations under this new model which I don't think was possible under the old China model.

Currently however, I still do not see where the cash freed up from the new model is going. Li himself stated that in the guidance conference call update that the company will not be producing television at maximum capacity due to supply constraints in the panels until after mid-2008.

I do not know how the author arrived at the estimates for revenue for calendar 2008 but it appeared to be a tad too high. Generously assuming that Vivitar digital camera revenue would be $100 million and the company can maintain somewhere around a $550 ASP (Average Scree Price) in calendar 2008, the company would still have to sell over 1.3 million units of LCD TVs to achieve $850 million in revenue. This 1.3 million units does not include those made by their licensed distrubutor in China.

For this quarter ending december, which is the busiest shopping season for LCD TVs, the company only expects to ship between 250,000 to 275,000 units when not counting those sold by their China distrubutor. With the panel supply constraints stated by the company, I do not see how units sold can be improved so darmatically to achieve $850 million in revenue.