Avid's 10Q Management's Discussion and Analysis has some important revelations which I believe bolster my opinion that the stock is overvalued based on future earnings potential. I've analyzed those sections which I think represent significantly greater risk than the standard disclaimers in this 10Q we're used to seeing, such as "sole source vendor" shortage possibilties:
"The Company expects that gross margins during 1997 will be slightly above 1996 levels, but will continue to be lower than 1995 and 1994 gross margins."
(Avid cannot afford to sacrifice any more profit margin to meet the significantly lower price points of many competitors in the marketplace; for now they still sell the Mercedes of nonlinear editing systems, but their competitors' products are getting better and better, and closer in feature set with each passing month. Avid Media Composers are widely known as being the most expensive systems to buy and especially to support and upgrade.)
"The Company's operating activities generated cash of $35.8 million in the first quarter of 1997 compared to using cash of $21.0 million in the first quarter of 1996. Cash was generated during the first quarter of 1997 primarily from collections in accounts receivable and reductions in inventory."
(While I commend management for finally bringing costs more into line after 5 losing quarters, cost-cutting can only go so far. We still have yet to see a resurgence of solid growth in both revenues and earnings, certainly nothing to warrant a PE ranging from 32 to 85 based on '97 earnings estimates or a PEG of 1.96 with a 5-year average growth rate of 20%.)
"The Company's systems and software products typically have higher gross margins than storage devices and product upgrades."
(I've been saying for some time that their systems and software are their bread and butter, but their software edge and the sophistication of their systems which drives their premium-pricing business model are both eroding as increasing numbers of competitors challenge them with commodity-priced hardware and less-expensive, albeit somewhat less refined and feature-laden software.)
"The Company has recently initiated steps designed to shift an increasing proportion of its sales through indirect channels such as distributors and resellers. The Company expects that this shift will result in an increase in the number of software and circuit board "kits" sold through indirect channels in comparison with turnkey systems consisting of CPUs, monitors, and peripheral devices including accompanying software and circuit boards sold by the Company through its direct sales force to customers. Therefore, to the extent the Company increases its sales through indirect channels, its revenue per unit sale will be less than it would have been had the same sale been made directly by the Company. In the event the Company is unable to increase the volume of sales in order to offset this decrease in revenue per sale or is unable to reduce its costs associated with such sales, profits could be adversely affected."
(In order to cut costs and sales personnel, Avid has chosen to shift towards selling through indirect channels. Interestingly, Media 100 (the #2 competitor), touts their indirect reseller sales channel as contributing to their success and higher profit margins due to reduced overhead. MDEA also has proprietary editing software, but they manufacture their own hardware, which is why they have always had higher gross margins (62% in 1Q97). In Avid's case, however, they are warning that such a distribution model will result in lower profit margins that can only be offset by an increase in sales volume. Another significant threat to profit margins moving forward.)
"In 1995, the Company shipped server-based, all-digital broadcast newsroom systems to a limited number of beta sites...Because some of the technology and products in these systems were new and untested in live broadcast environments at the time that such systems were originally installed, the Company provided greater than normal discounts to these initial customers...the Company has incurred unexpected delays and greater than expected costs in completing and supporting these initial installations to customers' satisfaction. As a result, the Company expects that it will report, in the aggregate, a loss on these sales, when all revenues and costs are recognized. The Company has recognized approximately $6.1 million in revenues from these initial installations and approximately $6.6 million of related costs. In future quarters, the Company expects to recognize an additional $1.6 million in revenues associated with the remaining initial installations. The Company has provided a reserve for estimated costs in excess of anticipated revenues. Revenues and costs are recognized upon acceptance of the systems by customers. The Company is unable to determine whether and when the systems will be accepted. There can be no assurance that the remaining initial installations will be accepted by customers or that the Company will not incur further costs in completing the installations. If customers do not accept these systems, the Company could face additional costs associated with reducing the value of the inventory included in the systems. The Company's overall gross margin percentage will be reduced in any quarter or quarters in which the remaining initial installations are recognized or written off. In 1996 and the first quarter of 1997, the Company installed additional server-based, all-digital broadcast newsroom systems at other customer sites. The Company believes that such installations, when and if fully recognized as revenue on customer acceptance, would be profitable. However, the Company is unable to determine whether and when the systems will be accepted. In any event, the Company believes that because of the high proportion of third-party hardware, including computers and storage devices, included in such systems, that the gross margins on such sales would be lower than the gross margins generally on the Company's other systems."
(Apparently, Avid still has yet to recognize all the sales and costs of their high-end newsroom systems going back to 1995. These earlier beta installations have been sold and supported at a loss. And there are still $1.6M in revenues to be recognized from these early installations. They are anticipated to be recognized at a loss, but there is also the risk that they will not be accepted by the customer, and therefore, the loss would be much greater. Sales of their more recent newsroom installations in 1996 and the first quarter of 1997 are "believed" to be profitable, but at lower margins than their other NLE systems. In addition, they still do not know when or if these more recent installations will be accepted by their customers and therefore recognized as revenue. Meanwhile, the cost of hardware, mostly hard drives and computers, has been plummeting during this 2 year period, while capabilities and performance has increased. And these commodity components represent a high proportion of the newsroom system sales. Surely these customers have to consider this when spending many hundreds of thousands of dollars, especially anyone who bought hardware a year or two ago that hasn't agreed to accept or pay for it yet. Avid is fighting rapidly diminishing returns with this extended period of product development, with lower margins on these system sales and component prices which continue to drop. This part of their business has the potential to signifantly impact earnings. In 3Q96, Avid took a $9 million charge for discontinuing its non-compressed Media Spectrum system. This company does not have a good track record developing high-end proprietary systems $250K and up, even though there is much less competition in this part of the market than at the middle ground where their bread and butter Media Composer NLEs are now competing with dozens of competitors.)
"The Company's operating expense levels are based, in part, on its expectations of future revenues. In recent quarters, 40% or more of the Company's revenues for a quarter have been recorded in the third month of the quarter. Further, in many cases, quarterly operating expense levels cannot be reduced rapidly in the event that quarterly revenue levels fail to meet internal expectations. Therefore, if quarterly revenue levels fail to meet internal expectations, the Company's operating results would be adversely affected and there can be no assurance that the Company would be able to operate profitably."
(I don't quite understand why this is so; it could be just a standard disclaimer, but I find it unsettling that so much of their quarterly sales are recorded this late in the quarter, with very little time to do anything about it should operating expenses be out of line with revenues.)
"In particular, the Company believes that it will be necessary to develop additional products which operate using Intel Architecture "(IA)"-based computers and the Windows NT operating system. There can be no assurance that customers will not defer purchases of existing Apple-based products in anticipation of the release of IA-based, NT-based products, that the Company will be successful in developing additional IA-based, NT-based or other new products or that they will gain market acceptance, if developed. Any deferral by customers of purchases of existing Apple-based products, failure by the Company to develop such products in a timely way or to gain market acceptance for them could have a material adverse effect on the Company's business and results of operations."
(Surely, R&D will have to be increased to simultaneously support a changing Macintosh environment as well as developing an entirely new line of Wintel platform NLE systems. Well, I guess they do have that cash from Intel! But this is the kind of product transition that can really be treacherous; the technical hurdles with bleeding edge technologies like digital desktop video cannot be treated lightly. Avid's transition from Nu-bus Macs to the PCI-bus Macs was the primary factor behind the company's slide in '95. It took nearly a year longer than other hardware manufacturers for them to convert over to PCI, and this delay resulted in high R&D, obselete inventory that had to be written off, and lost sales as customers held off buying for fear of purchasing built-in obselescence.)
Read the entire 10Q management's discussion on the Edgar site, or at this Yahoo page: sec.yahoo.com
As always, do your own research!
D. Kuspa |
