DSWL

Business Context and Reporting Period

Company: Deswell Industries, Inc.
Filing Type: Form 20-F (Annual Report)
Reporting Period: Fiscal year ended March 31, 2009
Business Overview: Deswell is an independent manufacturer of injection-molded plastic parts, electronic products, subassemblies, and metallic molds for OEMs and contract manufacturers. Operations are primarily conducted in Southern China, with administrative offices in Macao. The company is incorporated in the British Virgin Islands and reports in U.S. dollars under U.S. GAAP.

Key Financial Metrics (Fiscal Year 2009)

Material Changes vs. Prior Period

• Revenue Decline: Net sales decreased 8.4% to $131.7 million, driven by a 31.3% drop in the electronic and metallic segment ($26.6 million decrease), partially offset by a 24.8% increase in the plastic segment ($14.6 million increase).
• Margin Compression: Gross margin fell to 15.3% from 18.4%. This was caused by a shift to lower-margin products, a 10% rise in resin prices, a 2.5% appreciation of the RMB against the USD, and increased labor costs despite workforce reductions.
• Profitability Collapse: Operating income plummeted 91.4% to $745,000. The electronic and metallic segment recorded an operating loss of $589,000, compared to income of $2.1 million in the prior year.
• Customer Concentration: Sales to the two largest customers (N&J Company Limited and Digidesign Inc.) accounted for 41.3% of total net sales. Several major customers reduced order volumes significantly due to the global recession.
• Provisions and Charges: The company recognized approximately $3.0 million in charges related to provisions for doubtful accounts, inventory write-downs, and obligations for financially distressed customers.

Outlook, Risks, and Management Commentary

• Economic Outlook: Management expects the global economic weakness to continue negatively impacting operations over the next several quarters. Demand for customers' products remains weak, and pricing pressure is intense.
• Customer Risk: The company has no long-term contracts with customers. Loss of major customers or further order reductions would materially harm financial performance.
• Currency Risk: Continued appreciation of the RMB against the U.S. dollar increases operating costs. The company does not hedge currency risk.
• Supply Chain Risks: No long-term contracts exist for plastic resins or electronic components. Price volatility and potential shortages could adversely affect margins and production schedules.
• Regulatory and Tax Risks: New PRC tax laws have eliminated previous tax concessions, increasing the effective tax rate. Additionally, new labor laws in China restrict the ability to downsize the workforce during economic downturns.
• Subsequent Event: In August 2009, the company entered an agreement to sell a former manufacturing property in Shenzhen for approximately $7.3 million, expecting to record a gain in the third fiscal quarter of 2010.

Investor Verification Checklist

• Customer Concentration: Verify the stability of N&J Company Limited and Digidesign Inc., which together represent over 40% of revenue.
• Inventory Valuation: Review the $3.0 million in charges for doubtful accounts and inventory write-downs to assess the quality of remaining assets.
• Currency Exposure: Monitor RMB/USD exchange rates, as 35.1% of costs were in RMB while sales are primarily in USD/HKD.
• Dividend Sustainability: Assess the ability to maintain quarterly dividends given the sharp decline in net income (from $8.9M to $1.2M) and cash flow.
• Real Estate Sale: Confirm the closing of the $7.3 million property sale in Shenzhen and the timing of the associated gain recognition.