Pessimistic model for Q3 results
To Dale: Thanks for posting the results of your model for Q3. It encouraged me to post my analysis as well, which I had put together in late July after the disappointment of Q2 results. It didn't post it at the time because I thought I would probably be eaten alive when proposing a loss for Q3. But your analysis shows that others come up with similar results. Interestingly, I ended up in the same ballpark although I used a somewhat different approach in guesstimating results. I would be interesting to hear from you where your model significantly differs.
Please note: the remainder of this note was written back in July.
As many others on this board, I was very unsatisfied with the results for Q2. However, my main concern was not so much the 'manageable' EPS number but mainly the revenues growth (or lack thereof) and the lackluster prospect of more revenues downstream.
When thinking through some of the implications of the numbers presented and the comments made by management it occured to me that what Kim Edwards calls a 'challenging' third quarter might end up being a disaster for shareholders. I would like to present some simple back-of-the-envelope analysis here. It uses a bunch of assumptions. I would invite people to prove me wrong, but please with facts and numbers and not with wishful thinking ('great company, great management, great products').
Revenues breakdown
(in $m)
________________Q2______________Q3
ZIP drives_____170_____________162
ZIP disks_______20______________20
JAZ drives______45______________36
JAZ disks_______10______________10
Ditto___________30______________24
Misc____________10_______________8
Total__________285_____________260
Assumptions for Projections
- Summer season: Q3 will per se be 20% slower than Q2 (my assumption).
1) ZIP drives:
- Base demand for ZIP has leveled off at the retail level (my assumption). While there were severe shortages in Q1, ZIP was readily available in Q2 worldwide. However, (almost) all the revenue growth that was reported for Q2 ($60m) can be attributed to the large-scale introduction of Jaz. I assume no revenue growth without supporting measures.
- Rebate: Price to distributors $150 (my assumption); rebate $50 leads to loss of net revenues of 33% per unit; volume effect: Iomega said that going from $199 to $99 will quadruple demand; I assume that going from $199 to $149 will lead to increase in demand of 50% (ceteris paribus). At the same time, only domestic sales will be affected by the rebate, not export sales (see #4754 for explanation). I assume that IOMG's export quota is 50%.
- OEM: big question mark; some additional OEM will take effect in Q3; in Q2 OEM was only marginal; my concern: if the already operational OEM deals in Q2 did by themselves have no major share of total ZIP sales, what difference do a few more OEM deals make? My assumption: plus 20% of total ZIP sales.
- All in all: 0,8 x (85m x 0,66 x 1,5 + 85m) x 1,2 = 162m
2) JAZ drives: I assume that in Q3 the same will happen to JAZ that happened in Q2 to ZIP. The pent-up demand has been satisfied, sales will level off and settle at the same level than in Q2.
- Price drop by 20% will lead to demand increase of 25%, which means it's a wash in value terms.
- All in all: 0,8 x 0,8 x 1,25 x 45m = 36m
3) ZIP/JAZ disks: same absolute numbers as in Q2 as the summer slowdown is off-set by an increase in the number of drives sold.
Conclusion: Unless the above reasoning is proven dead wrong, we might experience quarter-to-quarter revenue growth of -10% or half-year growth of 14% (annualized 30%). I agree the numbers look like a worst-case scenario to die-hard IOMGeans, but are they really???
What's really worse is the effect that the above scenario would have on profits because IOMG is basically buying revenues by lowering prices. Here are some figures:
For Q2:
Net revenue____________100% ($284m)
Cogs____________________73% ($207m)
operating expenses______18% ($51m)
interest expense_________1% ($2m)
Profit before tax________8% ($23m)
Gross margin percentage in Q2 was 27%. I assume that it was 23% for drives and 50% for disks. This leads to COGS of $115 (=150 x 0,77) per ZIP drive and $300 (=375 x 0,77) per JAZ drive. Assuming an improved manufacturing cost position in quarter 3 over quarter 2 of 10%, IOMG will make gross margins of -$4 (=100-0,9x115) per rebated ZIP drive, and $46 (=150-0,9x115) per un-rebated ZIP drive and +$30 (=300-0,9x300) for each Jaz drive. The volume split of rebated to unrebated ZIP drives will be 60:40, leading to an average margin of $16 for retailed ZIPs. There is also pressure on margins for ZIP as the share of (low-margin) OEM deals increases; remember that ZIP is available on OEM machines for a surcharge of $99 and it's definitely not the OEM that takes on the loss. I assume a sales price to OEMs of $80. I come up with an average gross margin for all ZIPs of $8.
Total COGS will be:
ZIP drives: 162m x 0,92
JAZ drives: 36m x 0,9
disks: 30m x 0,5
misc.: 32m x 0,7
=> in total: $222 m
I assume operating expenses will be unchanged from Q2 in total amounts.
Pro-forma P&L for Q3
Revenues________________260
COGS____________________222
Operating exp.___________51
Interest exp._____________2
Loss____________________-15 (or -11c a share)
The underlying reason for this (theoretical) disaster is that if you have a gross margin percentage of only 27% and you cut prices of your major revenue contributor by 33% you're getting yourself in big trouble or you must be excellent in getting manufacturing and input costs down.
Of course these numbers do neither include the $4m carried forward from Q2 nor the potential 'cosmetical' tricks that can be applied to make the figures look better when they are released. For instance, the bottom-line effect of the rebates might be postponed to Q4. However, I am more interested in the underlying economics than in what is published, because the price for a (fundamentally) bad quarter has to be paid at some point. |
