Tuesday, June 30, 2009

Severity of Recession Trips Up Flow International

Chief executive Charley Brown of Flow International (FLOW-$2.39), a manufacturer of water-jet and routing machine tool systems for a variety of industrial applications, optimistically opined in a press release issued last week that although “the global economic slowdown continues to impact business, roughly two-thirds of its revenue stream has stabilized,” and the company is positioning itself for sustainable, long-term growth. Permit the 10Q Detective to proffer some skepticism, as red flags uncovered in Flow’s annual report for the year-ended April 30—combined with prior faulty predictions by Brown—suggest a successful turnaround is far from a certainty.

Fresh on the heels of a
multi-million Airbus contract, Brown braved the recessionary headwinds blowing last summer and optimistically told analysts on the 2008 earnings call that Flow would deliver 20 percent compounded EBID growth on a 10 percent annual increase in annual sales for fiscal 2009. To the contrary, the company posted a loss of $23.8 million, down from a profit of $22.4 million a year earlier, primarily driven by a $29 million charge to settle patent litigation and an aborted merger with smaller rival Omax and $6.9 million in restructuring charges recorded to reduce global staffing levels.

“It always looks darkest just before it gets totally black.” ~ Charlie Brown, Peanuts comic strip

Sales fell 14 percent to $210.1 million, resulting from a significant decline in system orders as customers delayed capital spending and expansion plans. In addition, although backlog increased 30 percent to $45.7 million, customers in North America and Europe negotiated for longer lead-times (from quote to purchase).

In our opinion, Brown erred in his 2009 guidance by mistakenly believing that Flow’s diversified revenue profile—spread across geographies and end-users—would shield the company from isolated industry-specific slowdowns. Although no single customer makes up more than five-percent of total sales and roughly 58 percent of revenue comes from customers outside the U.S., management under-estimated the breadth and scale of the global economic slowdown. In addition, the usually strong recurring revenue stream from spare parts dried up in 2009, falling five-percent year-on-year due to lower capacity utilization in customers’ operations.

At April 30, Flow held $10.1 million in cash, of which approximately $6.1 million was held by non-U.S. subsidiaries; working capital of $27.9 million plummeted to a skeletal $2.1 million (after backing out the $8.7 million in deferred tax assets and $17.1 million in deferred acquisitions costs payable to Omax); and, cash used in operations was $6.5 million. Should operations continue to deteriorate in coming quarters, this anemic balance sheet could weigh-down Flow’s growth/expansion plans, forcing the company to raise additional capital through financing vehicles potentially dilutive to existing Flow shareholders, such as a recently proposed $35 million
stock offering.

Irrespective of its operating performance, the company is responsible for covering more than $38 million in contractual obligations and commercial commitments coming due in 2010 – 2011, including operating leases - $5.5 million; current portion, long term debt, notes payable and capital leases - $5.0 million; and, purchase commitments - $23.3 million.

Just as worrisome, weak operating results in coming quarters would likely trip
loan covenants under existing credit facilities, too, further limiting the company’s ability to obtain financing on reasonable terms.

“In the book of life, the answers aren't in the back.” ~ Charlie Brown

Decreasing liquidity, questionable credit worthiness, and confutative ramblings of a chief executive—Flow International’s ability to deliver 20 percent compounded EBID growth rests entirely on a global economic recovery. If all else fails, management could always think positively, and manage its future earnings by decreasing the $20 million valuation allowance on its deferred tax assets—like it did in 2008!

Editor David J Phillips does not hold a financial interest in any stocks mentioned in this article. The 10Q Detective has a Full Disclosure Policy.

Friday, June 26, 2009

Rewarding Stupidity at Computer Portfolio Services

The share price of Computer Portfolio Services (CPSS-$0.69) has plummeted 89 percent in the last two years as its financial results continue to be hammered by credit losses in its managed portfolio of sub-prime auto loans. The specialty finance company is now alleging that the only way to motivate and retain key employees is to exchange and re-price outstanding stock options, according to its proxy statement. One might wonder how this exchange will create any long-term benefit—except dilution to the holdings of non-management shareholders.

Management insists that the best course of action for the company is to replace deeply ‘underwater’ stock option awards—with an exercise price greater than $2.50 a share—with new stock option grants. Options to purchase approximately 7.5 million shares are outstanding, of which options to purchase approximately 4.2 million shares would be eligible for surrender and exchange. Under the proposal, chief executive Charles Bradley has much to gain, owning 887,000 eligible options at an average weighted exercise price of $4.72 a share. Together, the top nine executives own almost 44 percent of eligible options (at an average, weighted price of about $5.00).

For fiscal 2008, the company posted total revenues of $368.4 million, a decrease of 6.6%, to $368.4 million. Net loss for the full year 2008 was $(26.1) million, compared to net income of $13.9 million in 2007, due to rising default rates and losses resulting from the sales of some packaged auto loans.

Management opines that the steep decline in Computer Portfolio Services’ stock price was mostly driven by factors external to how it operates the business:

Our management has taken actions to address the unprecedented economic environment. We undertook significant cost-reduction actions in late 2008 and early 2009. As of May 31, 2009, we have taken actions to eliminate a total of approximately $35 million of annual operating expenses for 2009. Among these actions are (i) a reduction in the number of employees from 873 at May 31, 2008 to 542 at May 31, 2009, (ii) a general freeze on salaries, suspending our long-established practice of annual adjustments, and (iii) as to officer-level employees, a 20% reduction in bonuses earned for achieving their personal performance goals in 2008. However, despite the actions we have taken to reinvigorate our business and improve our performance, our efforts have not had a significant effect on our stock price, which remains at a level significantly below that which prevailed in the years 2006 and 2007.

Following this logic, the 10-Q Detective argues that Bradley should return his cash bonuses of $1.06 million and $1.5 million that the Board rewarded to him for alleged performance in 2008 and 2007. As any farmer knows, when you plant the lettuce and it fails to grow well, you don’t blame the lettuce. Bradley and his team had no problem taking the accolades and the lettuce during the boom years!

Look, ain't no use in cryin'
Your story I ain't buyin'
Forget about it, ain't no use in tryin'
~ R&B singer-songwrite Montell Jordanl

A swap price of $1.00 per share—44 percent above the current price—would result in an incremental 12 percent hit to compensation expenses, or $457,000 (excluding tax-gross up considerations). If options are to remain a key incentive tool, tell us again how non-management shareholders benefit if top executives know that they will also be rewarded with stock option swaps if they screw up?

Editor David J Phillips does not hold a financial interest in any stocks mentioned in this article. The 10Q Detective has a Full Disclosure Policy.

Tuesday, June 23, 2009

Wyeth Heartburn for Pfizer

The state of Massachusetts announced Monday that it has joined fourteen other states in a pricing suit against Wyeth (WYE-$44.62), alleging that the drug manufacturer “knowingly failed to give the government the same discounts it provided to private purchasers” for its blockbuster GI drug Protonix. This litigation is just one in a litany of “at risk” problems Pfizer (PFE-$14.63), the world’s largest drugmaker, will inherit with its $68 billion acquisition of Wyeth, pending approval by the stockholders of both companies.

The states’ action follows on the heels of two
whistleblower lawsuits filed last month which allege that Wyeth avoided paying hundreds of millions in rebates due to state Medicaid programs for two versions—oral and intravenous—of Protonix.

Wyeth's sales performance to 2013 will be hampered by the patent expiry of four key products, including the $2.6 billion selling
Enbrel (rheumatoid arthritis and psoriatic drug loses patent in 2012) and its hemophilia drug Refacto (with patent expiry in 2010).

Wyeth has patent protection on its $3.9 billion anti-depressant drug,
Effexor, through 2010. The timing of generic launches, however, will likely impact the ability of the company’s sales representatives to “convince” prescribing physician that its follow-up compound Pristiq, a new antidepressant launched last year, is the “better” therapeutic agent.

Even drugs in the company’s portfolio with existing patent protection are no longer insulated from intrusion, as generic competitors are becoming more aggressive in their attempts to disrupt existing market exclusivity. For example, despite the existence of patent protection until 2010, Teva attempted in late 2007 to launch a generic version of Protonix tablets, with an intended goal of bullying Wyeth to essentially pay the Israeli-based generic firm as part of a
standstill agreement. A similar legacy awaits Pfizer with Wyeth’s $1.3 billion antibiotic drug Zosyn/Tazocin. Although the Food and Drug Administration granted patent extension on this key hospital product until 2023, Wyeth management admitted back in April that generics would likely be launched in the third-quarter.

One of the most promising drugs that Pfizer will inherit in Wyeth’s pipeline is the experimental vaccine bapineuzumab, which the company is developing with Elan for the treatment of Alzheimer’s disease. To date, released data is showing mixed results—both with efficacy and side effects. Of concern, in July 2008,
Phase 2 published results revealed that the drug worked no better in the patients with the gene that was a risk factor for Alzheimer’s disease as in those without the gene.

Pfizer will also inherit $5.6 billion and $1.9 billion in pension benefit and other post-retirement obligations (such as healthcare) owed to current and retired Wyeth employees. In addition, if the markets suffer more losses this year, the company could be forced to pony up more than the approximately $440 million Wyeth had planned to contribute to its qualified defined benefit pension plans (expected return on assets this year is 8.75 percent, according to the 2008 10-K). Of note, last year Wyeth contributed $664.6 million to its current pension plan to offset experienced investment losses (60 percent asset exposure to stocks).]

"Mama Mia! That's a spicy meat-a-ball!"

Lost profits to generics, pipeline setbacks, and rising pension obligations – management at Pfizer may need some Protonix for the heartburn sure to follow upon completion of the merger with Wyeth.

Editor David J Phillips does not hold a financial interest in any stocks mentioned in this article. The 10Q Detective has a Full Disclosure Policy.

Monday, June 22, 2009

No Smell of Profits at Matrixx Initiatives

Matrixx Initiatives (MTXX-$5.55) confirmed that it received a warning letter from the Food and Drug Administration about several of its 19 existing homeopathic Zicam products, specifically Zicam Cold Remedy Nasal Gel and Zicam Cold Remedy Swabs. The letter cited consumer reports that the use of these products could cause a temporary or permanent loss of smell, known as anosmia. The company is complying with the FDA request, but management is seeking a meeting with the FDA to defend the scientific data demonstrating the products’ safety. Nonetheless, the resulting adverse publicity could damage public confidence and kill sales across all product lines.

"Matrixx Initiatives stands behind the science of its products and its belief that there is no causal link between its Zicam Cold Remedy intranasal gel products and anosmia," said William Hemelt, Matrixx Initiatives' acting president in a press release. "It is well understood in the medical and scientific communities that the most common cause of anosmia is the common cold, which Zicam Cold Remedy intranasal gel products are taken to treat. Given the enormous number of doses sold and colds treated, there is no reason to believe the number of complaints of anosmia received is more than the number that would be expected in the general population.”

Management says, “no reliable scientific evidence exists that supports the claim that Zicam causes anosmia and that no plaintiff has ever won a product liability case against the company.” Still, that has not stopped folks from trying, with hundreds of lawsuits having been filed against the company since 2003. As part of the overall attempt to wind-down product liability litigation connected with Zicam, the company did settle approximately 500 of these lawsuits in recent years—at a cost of about $12 million. In addition, the company has spent almost $17.9 million on litigation expenses in just the last four years.

Hemelt had previously noted on the
2009 earnings call (ended March 31) that net sales would grow five-percent in fiscal 2010, representing a targeted amount of approximately $117 million. Based on forecast, share-net was expected to come in between 10 percent –to- 15 percent higher, at about $1.61 to $1.68 per share.

The company had factored into 2010 guidance that perhaps 20 percent of the oral Zicam cold remedy line was at risk from increased generic competition—but now all bets are off until management meets with the FDA to review safety issues. In our opinion, an FDA mandate requiring new safety studies would likely sink Matrixx.

Investors seduced by Matrixx Initiatives’ clean balance sheet—approximately $4.25 a share in cash and zero long-term debt—might pause and reflect on the fact that product recalls and a predicted slew of new lawsuits challenging the safety of Zicam will quickly drain the $51 million in working capital. In addition, the company acknowledged in its
2009 annual report that it is did not anticipate receiving any significant reimbursements from its insurance carriers in 2010. As of March 31, Matrixx had set aside only $785,000 and approximately $2 million in reserves for product liability litigation and product recalls, respectively. Oops!

The actual fallout from product recalls and the resulting publicity nightmare (adverse effect on allergy relief swabs business) could prove to be the killer cold virus for Matrixx, as cold remedy products (intranasal and oral) constituted almost 73 percent of its $111.6 million in sales last year.

Editor David J Phillips does not hold a financial interest in any stocks mentioned in this article. The 10Q Detective has a Full Disclosure Policy.

Tuesday, June 16, 2009

Insomnia for Somaxon Pharma Shareholders

Richard Pascoe, chief executive of Somaxon Pharmaceuticals (SOMX-$1.10), expressed confidence that the resubmitted New Drug Application of Silenor (doxepin) for insomnia in adults will address the FDA’s concerns about the drug's sleep maintenance efficacy and cardiac safety profile (risk of ventricular arrhythmias). Irrespective of a favorable approval, the commercial success of Silenor is far from a certainty.

It will take at least six-months for the FDA to complete its review—and the marketing window for Silenor is closing quickly, with the in-licensed patent for the treatment of chronic insomnia (when the inability to fall asleep last for more than three weeks) scheduled to expire in March 2013. In addition, although the company claims that Silenor’s
selective histamine H-1 blockade – and lack of specificity for re-uptake at other central nervous system target sites – makes the drug a good candidate for insomnia, it is unlikely that mechanism of action alone will be enough to convince physicians to switch from better established sleep hypnotics, which include Lunesta (eszopiclone), Ambien CR (and its generic zolpidem), and Restoril (and its generic temazepam).

Somaxon is running out of cash, and is expected to announce a highly dilutive capital offering by the end of July (likely stock-warrant units). Management has yet to formalize a strategic partnership with a pharmaceutical company that already has established access to the highest prescribing physicians of insomnia treatments, too. The longer it takes the company to announce a strategic deal, the less income it is likely to keep in a royalty-sharing arrangement.

It’s a common myth that your sleep quality decreases as you age. Existing Somaxon shareholders, however, have plenty of worries to keep them up at night.

Editor David J Phillips does not hold a financial interest in any stocks mentioned in this article. The 10Q Detective has a Full Disclosure Policy.

Thursday, June 11, 2009

GT Solar, Yingli & Others in Solar Space Unlikely to Profit From Higher Crude Prices

As crude oil futures cross the $72 a barrel mark—more than doubling off their December low of $35 a barrel, advocates of solar energy—likely giddy from breathing in too much carbon monoxide from auto exhausts—herald a probable industry turnaround, both in industry utilization (across the photovoltaic supply chain) and company-specific profitability. The solar advocates may want to reign in their enthusiasm, for judging from comments [ranging from] chief executive Tom Zarrella of GT Solar (SOLR-$6.96), a provider of specialized equipment for the solar power industry, to Liansheng Miao, chairman and CEO of solar module maker Yingli Green Energy (YGE-$15.02), a rebound in customer demand is still unlikely to occur prior to 2011.

Chairman Miao told investors on Yingli’s first-quarter 2009 earnings report that although the company remained confident in the future of the global solar market, current market and operating conditions had forced the company to reduce its 2009 production outlook to a range of 450 megawatts to 500 megawatts, down from a previous estimate of 550 to 600 megawatts.

Tom Zarrella announced last month that a slowdown in spending by customers for its photovoltaic (PV) equipment business would likely continue through fiscal 2010 ended March. Albeit the chief executive of GT Solar expressed confidence on the
earnings call that polysilicon customers would honor their existing photovoltaic purchase contracts, due to “anticipation of the promising long-term future growth of solar,” evidence presented in the recently filed 2009 annual report suggests that cancellation risks on existing multi-million dollar photovoltaic (PV) and polysilicon contracts remain high.

GT Solar’s two principal business categories, photovoltaic (directional solidification systems, or DSS units) and polysilicon (chemical vapor deposition, or CVD, reactors) contribute 82 percent and 18 percent of total revenue: DSS units are specialized furnaces that melt polysilicon feedstock and cast multicrystalline ingots from which solar wafers are made; CVD reactors are used to react gases at high temperatures and pressures to produce polysilicon, the key raw material used in solar cells. During fiscal 2009 ended March 28, the four largest customers by sales were: (i) LDK Solar Co., (ii) South Korea's OCI Company ,(iii) Yingli Green Energy, and (iv) Glory Silicon Energy Co., of JiangSu, China—accounting for approximately 20 percent, 17 percent, 14 percent, and 11 percent of revenue, respectively.

GT Solar expects to convert approximately 40 percent of its $341 million in DSS furnace order backlog to revenue by April 3, 2010 (consisting of 34 PV equipment contracts). The company admits, however, that capex budget cuts by customers has reduced visibility of forward order rates and that the company has been approached by existing customers about contract revisions, specifically the pushing out of delivery schedules of contracts in its order backlog.

Industry analysts contend that the risk of customers actually canceling contracts is limited, as GT Solar usually requires deposits of 20 percent to 40 percent of the value of the contract. Nonetheless, this has not proved a determent in preventing some customers from breaching the terms of their contracts. In fact, during fiscal 2009, some customers just walked away from their contracts, forcing the company to take an $11.5 million charge against earnings and to reduce its order backlog value by about $39 million.

All along the PV value chain—from raw material suppliers of polysilicon feedstock to the megawatts shipped and installed by solar module manufacturers—prices are still in freefall. Since hitting about $500 per kg last year, spot polysilicon prices have plummeted to around $70 per kilogram. Some forecasts are calling for solar-grade crystalline ingots to drop as low as $25 per kilogram. If true, this could prove to be bad news for fabrication wafer customers of GT Solar and good news to consumers.

The question still needs to be asked—and answered—however,
if commercial solar cell makers can improve utilization yields and lower variable costs enough to generate margin gains on end-product (gigawatts of solar modules) delivered to customers?

In a research note to clients, Hapoalim Securities analyst Gordon Johnson warned that solar industry fundamentals are in bigger trouble than expected by most observers. Many Chinese solar vendors are offering modules for prices far below what most American and European solar cell makers could conceivably operate at even marginal profitability. As recounted in Eric Savitz’s
Tech Trader Daily, Johnson asserts that some of his “most trusted industry contacts” say that companies like Yingli , Suntech, and Trina Solar are able to offer modules for sale at $1.70-$1.80/watt, or 1.21-1.28 Euros/watt, by slashing wages of their Chinese workers. He notes that at the recent Intersolar conference, the talk was that solar modules were priced in the 1.60-1.70 Euros/watt range.

At the risk of sounding obvious, the strategy of Yingli and other Chinese vendors is to leverage the cost-competitive advantage of its commodity-like business model to expand market share at the expense of its American and European competitors. Ergo, even though government policies towards alternative energy in the United States and European countries gives one reason to be confident in the future of the global solar market, it is unclear which players in their respective space along the PV value chain—stretching from Chinese silicon wafer makers LDK and Yingli, to fabrication equipment provider GT Solar, up the chain to fully-integrated manufacturers of everything from ingots to solar panels (like Canadian Solar)—will be left standing after the coming tectonic-plate shifting shakeout of seismic proportions.
Whether or not any solar company can generate sustainable profitability in the growing commoditization of the industry is another question best asked when the actual recovery occurs.

Editor David J Phillips does not hold a financial interest in any stocks mentioned in this article. The 10Q Detective has a Full Disclosure Policy.

Monday, June 08, 2009

Influence Peddling in Dell's Boardroom?

Dell (DELL-$12.08) struggles with another year of disappointing computer sales and a 63 percent drop in profits, and there is little scrutiny in the business press on the outlandish perquisites ($2,100 notebook computers and hundreds spent on technical support on how to use the PCs!) and egregious compensation (cash retainers and stock options worth up to $500,000 per annum) rewarded by the board to its members [save for the usual, first-rate disclosures by Michelle Leder’s footnoted.org site].

The pundits tell us less-informed folks that the board pay packages are justified because during these dire times directors are faced with even greater workloads and responsibilities.
Might the settlement of compensation have more to do with board members’ interests being aligned closer to those of top executives, however, than the amount and type of remuneration necessary to attract and retain talented directors?

The governing ethical principle at Dell is that “the interests of the stockholders are best served by having a substantial number of objective, independent representatives on the board,” according to the
2009 proxy filing. For this purpose, a director is considered to be “independent” if the collective members affirmatively determine that the director does not have any direct or indirect material relationship with Dell that may impair, or appear to impair, the director’s ability to make independent judgments. In a related decision, the NYSE and NASDAQ Exchanges expanded the definition of director independence in 2008 to include immediate family members, too, none of who could have received more than $120,000 in direct compensation (or related-transactions) during any twelve-months during the prior three years.

On the basis of the standards set forth above, Dell stated in its regulatory filing that only two of the 12 board members were not independent: Michael Dell and Donald Carty, best-known as the erstwhile chairman of American Airlines (until his retirement in 2003) and also a former Vice Chairman and chief financial officer of the PC Maker (from January 2007 – June 2008).

Independent Directors Unable—or Unwilling—to Make Independent Decisions:

  1. James W. Breyer, 47, joined the board in April 2009, and is currently a partner with the venture capital firm Accel Partners (located in Palo Alto, California). Dell and Michael Dell have a history of making investments as limited partners in several Internet-related ventures with Accel Partners.
  2. Director Sallie L. Krawcheck, 44, served as the chairman of Citi Global Wealth Management until January 2009. During Fiscal 2009, Dell was both a customer of and a supplier to Citi Global. Among other institutions of national prominence, Krawcheck serves on the board of Carnegie Hall and the University of North Carolina. [Like all Dell board members, observe a web of outside common interests.]
  3. Thomas W. Luce, III, a director from November 1991 – present, currently serves as chief executive of the National Math and Science Initiative Inc. (NMSI), a not-for-profit organization dedicated to expanding programs that have a proven positive impact on math and science education. The Michael and Susan Dell Foundation donated $1.5 million to NMSI in Fiscal 2009.

To list the activities of the other seven (alleged) independent directors would just serve as an exercise in overkill—not one member is involved in a charity or business where interests do not collide. Irrespective of what the company says, the ancient Greek lyric poet Pindar best captured the essence of “influence” on decision-making at Dell when he wrote: “even wisdom yields to self-interest.”

Dell was displaced as the top U.S. PC maker for the first time since 1999, according to research firm IDC, falling behind Hewlett-Packard in its first-quarter 2009. Given the board is failing shareholders—including Michael Dell (who still owns 11.83% of the company)—here’s a suggestion: the decisions of the existing board are obviously self-serving and of little value to stockholders and your own family’s financial well-being [Mr. Dell]. Throw the bums out and bring into the boardroom some college [geek] dropouts—like yourself—who actually know how to use a computer. It would certainly be less expensive and might actually yield some positive gains to the company’s bottom-line!

Editor David J Phillips does not hold a financial interest in any stocks mentioned in this article. The 10Q Detective has a Full Disclosure Policy.

Friday, June 05, 2009

Electronic Arts Defaults on Lease Covenants

Electronic Arts (ERTS-$23.13), home to some of the most popular PC games of all time, including the blockbuster Sims, Madden football, and Rock Band franchises, reported a loss of $1.08 billion for fiscal 2009 ended March, hurt by weaker-than-expected holiday sales and an admitted failure to score enough big sellers on the most popular game console system, Nintendo’s Wii. The video game publisher can weather the current downturn in consumer spending, as it sits on more than $2.1 billion in cash, according to its annual regulatory filing with the SEC. Curiously, as Wall Street analysts argue amongst themselves about the merits of EA driving growth by staying on roads well-traveled—reliance on churning out sequels to pre-existing hits and producing big, expensive Hollywood-style games (think the oft delayed Harry Potter and the Half-Blood Prince)—not one analyst bothered to voice any concerns on information buried deep in the body of the regulatory filing—the fact that the video game maker almost defaulted on real-estate loan covenants!

Electronic Arts leases certain of its current facilities, furniture, and equipment under non-cancelable operating lease agreements (recorded as off-balance sheet commitments). In February 1995, the company entered into a build-to-suit lease for its headquarters in Redwood City, California. This facility comprises a total of approximately 350,000 square feet and provides space for sales, marketing, administration and research and development functions. The lease expires in January 2039.

On February 2, 2009, the lease was amended to modify the Fixed Charge Coverage Ratio, the Quick Ratio and the Consolidated EBIDTA definitions used in the covenants. In the event that the company had not entered into this amendment, which covered the quarter ended December 31, 2008, as well as future quarters, Electronic Arts would have been unable to meet the Fixed Charge Coverage Ratio for the December quarter—default!

In December 2000, the company also entered into a second build-to-suit lease to expand the Redwood City headquarters facilities by an additional 310,000 square feet. Development of the adjacent property was completed in June 2002. Similar to the 1995 lease, had the company not modified the Fixed Charge Coverage Ratio, it would have been in non-compliance of that lease, too.

The two lease agreements are with KeyBank National Association. The following table sets forth the amended financial covenants as of February 2, 2009 (all of which EA is currently in compliance with as of March 31, 2009):

Are the financial covenant issues more an annoyance than an omen of future balance sheet concerns? Afterall, EA could purchase both properties for $247 million, according to related arrangements disclosed in the 10-K filing.

Fixed charge coverage rato indicates a firm’s ability to satisfy fixed charge obligations (such as bond interest and lease payments). As previously mentioned, EA is sitting on more than $2.0 billion in cash—more than enough to meet its fixed charge obligations. In singularity, the lease issues are irrelevant. However, if EA keeps churning out recyled versions of “in-the-box” units for PC-platform games while ignoring the explosion of software apps being written for iPhone, Facebook, and 3-D
Second Life virtual gaming communities—EA could find its cash hoard being eaten faster than the tape of an eight-track cartridge.

Even scarier is
the rise of free games. As presciently opined by Dean Takahashi last month in VentureBeat: What happens when the user decides that free is best? This is the same problem that newspapers, movies, music, and other producers of content are facing as the Internet undercuts the traditional barriers that have kept prices high.

As EA grapples with a weak consumer spending environment and the changing dynamics of interactive entertainment, fissures are opening up on the balance sheet: cash generated from operations plummeted 96 percent to $12 million and shareholder equity fell 28 percent to $3.1 billion. Nonetheless, chief executive John Riccitiello remains cautiously optimistic on the sales outlook for 2010, telling analysts on the
earnings call that a strong lineup of titles on EA’s core platforms (PS3, Xbox 360, and Nintendo Wii), including The Sims 3, Tiger Woods PGA Tour 10, and Harry Potter should drive sales and profitability.

In my opinion, EA’s wireless, digital service initiatives will define the financial health of the company in the years ahead. The digital business is currently scaled at over $400 million and is growing north of 20 percent per annum. Although wireless sales will contribute only about 10 percent of anticipated revenue of $3.7 billion to $3.85 billion in fiscal 2010, EA remains committed to being the number one publisher in wireless in North America and Europe combined, said Riccitiello.

EA’s global publishing footprint has long been a strategic advantage for the company. Setting the investment stage in wireless and making their games more accessible to a broader audience, including social networking (such as
Pogo on Twitter!) will, in my opinion, strengthen further its balance sheet in coming years, too. Or, as Oliver Wendell Holmes said: “it is not so much where we stand, as in what direction we are going.”

However, with management providing 2010 guidance of additional losses in the range of $0.85 to $1.45 per share, EA could find itself amending lease - loan covenants once again.

Editor David J Phillips does not hold a financial interest in any stocks mentioned in this article. The 10Q Detective has a Full Disclosure Policy.

Monday, June 01, 2009

Nothing for GM Common Stockholders

To no one’s surprise, General Motors Corp. filed for Chapter 11 bankruptcy on Monday. According to published reports, the largest U.S. automaker will issue new stock to the company’s retiree health care trust, the Voluntary Employees' Beneficiary Association (VEBA), totaling 17.5 percent of the equity in the new GM (and warrants to purchase another 2.5 percent). GM also has agreed to give the governments of Canada and Ontario a stake of about 12 percent. The U.S. Treasury and current bondholders will own around 60 percent and 10 percent, respectively. Add the equity shares up and it equals zero for existing common shareholders. Why is the stock selling for 75 cents a share? “Hope springs eternal in the human breast,” said the English poet Alexander Pope.

Editor David J Phillips does not hold a financial interest in any stocks mentioned in this article. The 10Q Detective has a Full Disclosure Policy.