Cavium Is Counting on New Products To Boost Underwhelming Earnings Quality

Cavium is bullish on a pipeline of new products, but analysts who discount the upbeat executive pronouncements may want to spend more time questioning just how sustainable the profits from its current operations are, and spend some time pondering the risks associated with new product launches in the current environment.

Cavium Inc. (CAVM.O) is trumpeting its array of new products – a new NEURON search processor and its OCTEON fusion products, which will help its customers speed up the process of accessing data via their mobile phones or using local wireless networks and routers. (Their biggest single customer is Cisco (CSCO.O).) The semiconductor manufacturer’s managers were very upbeat discussing the market potential of these new offerings during their most recent earnings conference call, noting that they didn’t expect the macroeconomic slowdown to affect demand.

In spite of that pipeline of new products, however, by one measure, Cavium displays signs of being a company that is unlikely to sustain its current level of profitability. It scores a mere 5 on the StarMine Earnings Quality (EQ) model, at least in part because of the precipitate decline in its operating profit margins. Margins for the trailing four quarters have plunged from 11.4% in the third quarter of 2011 to -14.8% in the third quarter of 2012, and currently languish far below the industry median (represented by the yellow line in the chart below. The onus will be on Cavium’s new products to reverse this decline, but it’s impossible to predict yet whether they will be as popular with customers as management expects them to be. Some of these products began shipping in the third quarter, so beginning in the fourth quarter, Cavium’s results should begin reflect their impact.

When Cavium unveils its quarterly results to the public, it chooses to do so on a pro-forma rather than a GAAP basis. It is required to present its GAAP earnings and show the reconciliation between the two forms of accounting, and it does so. But the company’s choice to offer an alternative view of its earnings can prove distracting, as the pro-forma presentation excludes certain kinds of costs — stock-based compensation, say, or the decision to capitalize research and development costs at various stages of development) before calculating the company’s bottom line results for the period. (This is a not uncommon tendency among technology firms, where both R&D spending and stock-based compensation are more significant.)

In the chart below, the green portions of the bars signal when GAAP earnings exceed pro-forma profits, and red mark the occasions when GAAP results trail pro-forma earnings. The red bars represent the expenses that Cavium excludes from the original pro-forma calculation, with the top of the bar showing the level of pro-forma earnings that Wall Street analysts accept and publish as the company’s “actual” results. The bottom of the bar represents the GAAP earnings. In the quarter that ended September 2012, for instance, Cavium reported earnings of 15 cents per share. However, when Cavium filed its 10-Q using the SEC-mandated GAAP standard, that became a loss of 16 cents a share. That is because – as Cavium noted in the third-quarter press release – the company had excluded from its pro-forma bottom line a total of $15.1 million of expenses relating to stock-based compensation, the amortization of certain intangible assets; acquisition and restructuring related expenses and a loss on the sale of other assets. In the short run, healthy pro-forma earnings may look good, but over the long term the trend identified by GAAP results is usually the one that prevails. That is significant, since Cavium has consistently reported pro-forma earnings significantly higher than those they ended up reporting when they filed their GAAP-compliant reports with the SEC. The magnitude of expenses excluded from its income statement on a pro-forma basis causes the company to score a weak 7 on the exclusions component of the EQ model.

Another reason behind the low StarMine EQ score is Cavium’s rising inventory levels. In each of the last four quarters, the year-over-year increase in inventory days was more than 80 days, while the number of inventory days increased from 137 to 235 days over the same four-quarter period. Of course, part of that increase in inventory levels may be due to Cavium’s preparations for rolling out a new product line. But as with any new product launch, it comes with uncertainty – and as is particularly true as innovation leapfrogs the previous generation of products, replacing it with new products. That means that the risk associated with an inventory buildup is significant. If for any reason the new products aren’t met with the kind of enthusiastic welcome by buyers as Cavium executives anticipate, the value of those inventories could decline very rapidly indeed.

During a recent earnings conference call, Syed Ali, Cavium’s president and CEO, noted that the company expects its sales and general expenses, as well as its research and development budget, to rise in short-term. Ali signaled that this was part of an effort to generate greater revenues that he expects to bear fruit within a few quarters. That may prove to be the case, but while waiting, investors are being asked to take a kind of leap of faith. We are in the midst of a weak macroeconomic environment, one in which many companies are cutting back on their new IT spending. Amidst that kind of uncertainty, it would be logical for investors to put more weight on the company’s current stream of earnings – and the signs that this may not be sustainable – than on what will happen in the future.

 
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