Is Emcore Blinded By the Light?

Sep.19.08 | About: EMCORE Corporation (EMKR)

On August 7, 2008, Emcore Corp. (NASDAQ:EMKR) announced in a press release that: 

[C]onsolidated gross margin for the quarter ended June 30, 2008 improved to 18% compared with 12% as reported in the immediate prior quarter.

In that same press release, Emcore stated that:

[O]perating loss for the three and nine month periods ended June 30, 2008 totaled $11.6 million and $33.8 million, respectively, which represents a significant decrease in operating loss when compared to the prior year quarter and the prior year losses of $13.5 million and $40.8 million, respectively.

I believe that the improvements touted by Emcore were created by managing the allowance for excess and obsolescence, a reserve account for inventory. Historically, the allowance as a percentage of gross inventory and the cost of revenue as a percentage of revenue were as follows (all numbers in thousands):

click to enlarge

Click to enlarge

Prior to the June 2008 quarter, the allowance as a percentage of gross inventory never dipped below 20%. Then, for the quarter ended June 30, 2008, the allowance as a percentage of gross inventory fell to 12%. In fact, gross inventory dropped $2.5 million from the March 2008 quarter to the June 2008 quarter, yet net inventory (gross inventory less allowance) went up $6.5 million. The drop in the allowance as a percentage of gross inventory does not seem warranted, given the fact that the cost of revenue as a percentage of revenue for the June 2008 quarter seems in line with prior quarters and years.

If the allowance as a percentage of gross inventory should be 23% for the June 2008 quarter, then the allowance for excess and obsolescence should be $13.017 million ($56.594 million X 23%). This allowance would result in a $6.489 million decrease to inventory and a corresponding $6.489 million increase to cost of revenue. A $6.489 million increase to cost of revenue would cause gross margin to drop to 9.48%, which is almost half of the stated gross margin of 18% for the June 2008 quarter and even lower than the 12% reported in the March 2008 quarter. A $6.489 million increase to cost of revenue would also elevate the operating loss for the three and nine month periods ended June 30, 2008 to $18.1 million and $40.2 million, respectively.

The alteration of the allowance for excess and obsolescence is alarming for several other reasons. Emcore's stock price (5.13 as of September 17, 2008) has risen 15% since their press release on August 7, 2008, when its stock price closed at 4.46. Emcore is considering splitting its fiber optics and photovoltaic businesses into separate corporations. The lower allowance for doubtful accounts and higher unbilled receivables have not been considered. Finally, the lower allowance for excess and obsolescence for the June 2008 quarter leaves little room for manipulation in the September 2008 quarter.

Disclosure: Author is short EMKR.