PMC-Sierra Adjusts Channel Accounting

In a trend I expect to snowball, PMC-Sierra (PMCS) announced they will begin using sell-through accounting as opposed to sell-in accounting with distributors. This is a trend which traces it’s origins back to the accounting issues at Vitesse Semiconductor (VTSS.PK). (see “The Trickle Down Economics of Channel Stuffing“)

As announced during the Company’s first quarter earnings conference call on April 25th, 2007, PMC-Sierra completed a review of its expanded global distribution arrangement with its largest distributor, Avnet, Inc. (AVT) As a result of completing this review, PMC-Sierra determined it was appropriate that all future revenues generated through Avnet be reported on a ’sell-through’ basis and therefore deferred until inventory is sold to the end customer.

Sell-through provides a more accurate picture of the health of the business and reduces the ease of which distributors can be used to perform channel stuffing. (see here for a discussion of the difference between sell-in and sell-through)

Suppliers of commodity products like memories, generic processors, and passives have a legitimate reason to use sell-in accounting. They have thousands or even tens of thousands of end customers and distributors provide a valuable service abstracting this order flow.

Companies like PMC, which do 80% of their business with a handful of customers, have little reason to use sell-in accounting. In my opinion, they have little reason to use distributors at all for a majority of their revenue.

I expect other component companies are examining the same issue, and unlike PMC, many of them have have plenty of bodies (aka worthless inventory) buried at distributors. The Boards of Directors of these companies should realize that a failure to act may put themselves and the company in a position of shareholder liability if abuse of the channel is not addressed as a governance issue.

PMC appears to made minimal use of sell-in accounting recently and therefore had little to lose from coming clean.

The net impact of this adjustment in the second quarter of 2007 was a decrease in reported revenue of $4.2 million, a reduction of $0.8 million in cost of sales, and an increase of $3.4 million in deferred income on the balance sheet.

AMCC recently announced a massive revenue shortfall, with a large amount of the shortfall due to a massive drop in channel revenue. They claim that this revenue will return. One must wonder if this was a Herculean effort to mop up inflated channel inventory. (see “AMCC Kicks the Distribution Habit“)

It is unclear how much stuffing the channel contributres to distributor revenue. Nu Horizons (NUHC)second largest supplier was Vitesse, which stopped all use of sell-in accounting one year ago. Nu Horizons profitability has slipped in the past 9 months, as I postulated last fall.

Author is short NUHC and holds an immaterial short position in VTSS.