Trickle Down Economics and Channel Stuffing

It’s very profitable for distributors - while it lasts. I examine the recent disclosures from Vitesse Semiconductor and the potential impact on their largest distributor, Nu Horizons.

McAfee (MFE), the manufacturer of anti-virus software, was alleged to have overstated revenues by $611M from 1998 to 2000 by shipping excess inventory into their distribution channel. McAfee settled with the SEC and paid a $50M fine. The details of what took place are documented in an extensive SEC filing (EDGAR link - read this). The filing highlights not only the activities undertaken by McAfee to enhance revenues, but also the exceptional profit opportunities this created for McAfee distributors.

From McAfee vs. Security and Exchange Commission

McAfee offered its distributors lucrative sales incentives that included deep price discounts and rebates in an effort to persuade the distributors to continue to buy and stockpile McAfee products. McAfee also secretly paid distributors millions of dollars to hold the excess inventory, rather than return it to McAfee for a refund and consequent reduction in McAfee’s revenues. In other instances, McAfee used an undisclosed, wholly-owned subsidiary, Net Tools, Inc., to repurchase inventory that McAfee had oversold to its distributors.

A search of the EDGAR database with the terms “Channel Stuffing” will uncover many more companies that engaged in this behavior, such as Sunbeam and Bristol Meyers.

During a conference call on July 27^th (EDGAR transcript here, my summary here), Vitesse Semiconductor (VTSS.pk) announced it was investigating practices that allowed it to recognize revenue beyond actual customer consumption.

From the conference call transcript:

The cash management techniques employed immediately prior to the quarter end include: the factoring of receivables, shipping large amounts of goods to distributors and negotiating incentives for distributors to remit cash on those shipments prior to quarter end… these activities have stopped.

While the Vitesse situation is much smaller in magnitude when compared with McAfee, it is probable that its distribution partners received incentives like those extended by McAfee. Now that these practices have stopped, consider the following questions:

1. Which Vitesse distributor received these shipments and potentially profited from these transactions?
2. How much operating income did the distributor gain from such transactions? What impact will the elimination of incentives have on earnings?
3. What future risks to this distributor exist if other companies engaging in this practice decide to stop?

If the distributor is small enough, and the supplier large enough, these incentives can be a significant share of operating income and drive increases in operating results.

Which Distributor Benefited?

Vitesse lists only one distributor on it’s website for the US and Asia ex-Japan. That distributor is Nu Horizons Electronics (NUHC). Vitesse also lists a distributor in the United Kingdom - DT Electronics Ltd - which was recently purchased by Nu Horizons.

Email feedback from Nu Horizons confirms that Vitesse is their 2nd largest supplier and accounted for $78.6M (16.6% of FY06 COGS) of total inventory purchases for FY06 (YE Feb. 28 06). Vitesse revenue for roughly the same the period was $199M, therefore 40% of Vitesse revenue was sold through Nu Horizons in the year prior to Feb 28, 2006.

Given that Nu Horizons accounts for the majority of Vitesse distribution, it is a reasonable assumption that they received most of the material Vitesse accelerated.

Vitesse increased FQ106 revenue by $6.4M and FQ206 revenue by $10.5M by shipping additional inventory to distributors. In FQ306, Vitesse burned off $3.1M in distribution inventory by shipping $3.1M less than end customers consumed through distribution. (Note these numbers are un-audited and are Vitesse estimates from the July conference call).

Assuming Nu Horizons was the recipient, this activity would require them to cache $6.4M of unnecessary inventory in their FQ406 (quarter ended Feb. 28 06), and $16.9M (6.4M+10.5M as the deficit was accumulating) in FQ107 (quarter ended May 31 06). The overall inventory level should be reduced by $3.1M to a balance of $13.8M in the current Q207 (Aug 31, 2006).

Vitesse was engaging in deficit financing by shipping more product than needed while still collecting cash. Their distribution partners provided the cash flow and in exchange carried excess inventory.

What was this Transaction Worth?

Insufficient information exists to reach a quantitative conclusion about what financial gains Nu Horizons could have derived from this transaction. The franchise agreements with suppliers that spell out contact terms are not available to investors. However, just as McAfee distributors realized lucrative incentives from accelerated shipments, it is likely Nu Horizons realized some short term benefits from Vitesse shipment acceleration.

Suppliers typically ship inventory to distributors at the end of the quarter, therefore Vitesse shipments made during their FQ106 (December 31, 2005) would be received during Nu Horizons FQ306 (Feb 28, 2006). Vitesse Q206 shipments would be received in Nu Horizons Q406.

Distributors demand additional compensation to stock inventory beyond a given time frame, usually 90 days. It appears that Nu Horizons carried a large quantity of material for Vitesse, and it is unclear what compensation was received in return. However, any compensation that was received was revenue with radically higher operating margins than Nu Horizon’s component distribution business.

Component distribution is a business with razor thin margins. Nu Horizons has 15% gross margins and SG&A costs that are 12-14% of revenue, and stated in their FQ107 conference call that a large portion of SG&A costs are based on sales incentives. These costs are incurred only when material is shipped to an end customer. Based on the latest 10Q, 81% of SG&A costs are associated with bonuses, commissions, and salaries – but these costs shouldn’t be incurred when receiving compensation for inventory that isn’t sold.

If this took place, operating margins for Q306, Q406, and Q107 would be significantly enhanced. The P&L statements show this is exactly what has happened.

Vitesse disclosed that $23M of its cash burn since January was due to expanding inventories. Investors that I spoke with assume this was excess inventory built at suppliers – but what if this was inventory bought back from their distribution chain?

Distributors who sold back this material, certainly sold back at a premium in order to cover carrying costs, would realize an excellent one-time gain with no associated SG&A. It would also indicate that the distributor is no longer carrying (and therefore profiting from) excess inventory.

I tried to get Nu Horizon’s perspective on my speculation. As part of a continuing conversation with Paul Durando, Nu Horizons CFO, I sent the following email to the company.

Have you listened to the Vitesse conference call?

They discussed excess shipments to distributors and incentives provided for doing so. They also discussed accelerated cash payments from distributors.

Can you answer the following questions?

1. What percentage of Vitesse resale revenue was made under the 'sell-through' model vs. the 'sell-in' or Point-of-sale model?

2. Can you provide some details on how this activity affected your Q306, Q406, and Q107 operating results and inventories?

3. Are there any risks associated with obsolete inventory as a result of this activity?

I am making the assumption that such activity is very profitable for Nu Horizons.

I have not received a response.

What Risks Exist Now?

• Reduced Operating Margins - Sales incentives have much lower associated SG&A, and therefore flow to operating income with higher margins than the core distribution business. If Nu Horizons was receiving incentives from Vitesse, and those incentives have stopped, their operating margins will contract.
• Reduced Future Margins - If Vitesse has stopped shipping excess inventory into distribution, distributors will have less leverage when renegotiating franchise agreements (resale margins in particular)? Vitesse will no longer be needy in their negotiations, and be forced to grant larger distribution margins in order to secure a distributor willing to take excess inventory. Vitesse is Nu Horizons second largest supplier and a key source of value added distribution income.
• Inventory Risk - Suppliers that aggressively ship into distribution channels typically are facing challenging financial conditions. Once a distributor agrees to accept inventory beyond what it can easily sell, they are no longer a distributor- they are a business partner. Stocking useless inventory exposes a distributor to great risks if the supplier were to become insolvent and incapable of honoring credits and returns.

  From the Nu Horizons FY06 10-K

  For example, at fiscal year end, each additional 1% of obsolete inventory or if the Company was unable to return inventory pursuant to its distributor agreements and could not be returned under our many distributor franchise agreements, would reduce operating income by approximately $1,250,000 for the year ended February 28, 2006.

  Another way to look at this is each additional 1% ($1.3M) of obsolete inventory would reduce operating income $0.07 a share. Nu Horizons earned $0.17 in FQ107, and $0.27 for all of FY06. Vitesse appears to have shipped $16M more product than necessary during two quarters – assuming Nu Horizons was the recipient, how much of this inventory is still fresh and how much could they return?

Summary

History shows that McAfee, Bristol Meyers, Sunbeam and many other companies who accelerated shipments to distributors offered lucrative financial incentives. While my conclusion relies on many assumptions, historical precedent shows Nu Horizons likely benefited from activity that has now ceased according to Vitesse.

Ultimately, it is the responsibility of the Boards of Directors of component companies to investigate the practice of using sell-in rather than sell-through as a means for recognizing revenue. Modern inventory systems have all but eliminated the need to use sell-in as an accounting method.

Xilinx (XLNX) was the largest supplier for Nu Horizons with $104.6M (22% COGS) and Sun Microsystems (SUNW) was third with $75.5M (16%). Vitesse and these three companies accounted for 55% of inventory purchases (calculated as a % of COGS). If Xilinx and Sun Microsystems use sell-in methods similar to those used by Vitesse, these transactions should be investigated by the audit committees of each company.

Disclosure: I hold Vitesse Semiconductor stock and am short Nu Horizons.