I have read a couple of recent articles alluding to improper dealings between Syntax-Brillian Corporation (BRLC) and Taiwan Kolin Co., Ltd. ("Kolin"), BRLC's primary supplier and major shareholder. Kolin grants price protection rebates to BRLC based upon the impact of market prices for LCD television products and components. But price protection rebates, which reduce BRLC's cost of sales, actually dropped from $61.0M for the year ended June 30, 2006 to $4.3M for the quarter ended September 30, 2006.
Price protection as a percentage of cost of sales dropped from 36% ($61.0M/$169.1M) for the year ended June 30, 2006 to 6% ($4.3M/$71.2M) for the quarter ended September 30, 2006. So you would not expect cost of sales as a percentage of sales to decrease due to the lower price protection rebates. However, cost of sales as a percentage of sales fell from 88% ($169.1M/ $193.0M) to 82% ($71.2M/$87.0M). How does the cost of sales as a percentage of sales decrease when the price protection rebates drop drastically?
SEND IN THE RESERVES
I believe the answer lies in the provision for inventory reserves. BRLC's inventory policy is to state inventory at the lower of cost or net realizable value; for the year ended June 30, 2006 and the quarter ended September 30, 2006, inventory was stated at net realizable value. The provision for inventory reserves was $2.9M for the year ended June 30, 2006, but swung to a negative $5.3M for the quarter ended September 30, 2006. A negative provision for inventory reserves means that inventory reserves were marked down, overall inventory was marked up, and cost of sales was marked down.
A negative provision for inventory reserves does not seem warranted for the following reasons:
1. The amount of the negative provision for the current quarter ($5.3M) is far greater than the amount of the positive provision for the entire last fiscal year ($2.9M).
2. Inventory write-downs totaled $5.6M for the last fiscal year and still totaled $1.7M for the current quarter.
3. Overall inventory increased to $40.7M as of September 30, 2006 from $13.2M as of June 30, 2006. With inventory increasing so dramatically, the inventory reserve would be expected to go up as well.
Either the negative provision for inventory reserve was fraudulent or it affects prior inventory valuations and cost of sales. Either way, the provision for inventory reserve should not affect the current cost of sales. Therefore, at least $5.3M should be added to the current cost of sales.
I GUESS YOU’RE JUST WHAT I NEEDED
If the provision for inventory reserves is added to the cost of sales, the cost of sales as a percentage of sales is 88% ([$71.2M + $5.3M]/$87.0M) for the quarter ended September 30, 2006. This figure is more realistic for the current quarter given that the adjustments for inventory reserves are due to fraud, at worse, or due to a prior build-up of the inventory reserves, at best. The figure is also more intuitive for the current quarter since the cost of sales as a percentage of revenue would not be expected to decrease given the drastic drop in price protection rebates.
If the provision for inventory reserves is added to the cost of sales, the operating income of $7.0M becomes an operating income of $1.7M and the net income of $3.8M becomes a net loss of $1.5M for the quarter ended September 30, 2006.
This reversal is alarming especially in light of BRLC’s recent stock movement. BRLC’s stock price (8.45 as of November 20, 2006) has risen 35% since it reported its results for the quarter ended September 30, 2006 on November 2, 2006, when its stock price closed at 6.26.
Disclosure: Author is short BRLC.
BRLC 1-yr chart: