Business Context and Reporting Period
Franklin Wireless Corp. designs, manufactures and sells 3G and 4G wireless data communication products, including USB modems and wireless modules, serving wireless operators, distributors and strategic partners primarily in the United States, South America, the Caribbean and other international markets. This Form 10-Q covers the three months ended September 30, 2013, the company’s fiscal first quarter, with comparisons to the three months ended September 30, 2012.
Key Financial Metrics
| Metric | Q1 FY2014 | Q1 FY2013 | Change |
|---|---|---|---|
| Net sales | $1.407 million | $13.137 million | Down 89.3% |
| Gross profit (loss) | $(3,192) | $3.180 million | Margin declined to (0.2%) from 24.2% |
| Operating expenses | $1.601 million | $1.922 million | Down 16.7% |
| Operating income (loss) | $(1.604 million) | $1.257 million | Turned negative |
| Net income (loss) | $(1.171 million) | $642 thousand | Turned negative |
| Net loss attributable to parent | $(1.094 million) | $739 thousand income | Turned negative |
| Diluted EPS | $(0.11) | $0.06 | Turned negative |
| Cash flow from operations | $165 thousand | $6.562 million | Down substantially |
Cash and cash equivalents were $10.495 million at September 30, 2013, compared with $10.431 million at June 30, 2013. Total current assets were $13.526 million and total current liabilities were $3.516 million, producing reported working capital of approximately $10.010 million. Total debt consisted primarily of $139 thousand of short-term bank borrowings; the loan was extended to March 2014 at an interest rate of 10.55%.
Net cash used in investing activities was $69 thousand, including $139 thousand of capitalized development costs. Financing cash flow was zero, compared with $2.406 million used for stock repurchases in the prior-year quarter. Management stated that available capital was sufficient to fund existing operations and obligations through at least September 30, 2014, although failure to achieve the business plan or obtain additional funding could require curtailment of operations.
Material Changes Versus the Prior Comparable Period
- Sales declined by $11.730 million, principally because of lower U.S. demand for USB modems, discontinuation of a chipset used in one product, the absence of repeat purchases from a large customer, lower WiMAX sales in South America and the Caribbean, and lower sales by the Korean subsidiary.
- Sales mix shifted materially: United States sales fell to $1.080 million from $11.952 million, while EMEA sales increased to $299 thousand from zero due to a new African carrier customer.
- Gross margin fell to negative 0.2%. Management attributed the deterioration partly to fixed amortization costs included in cost of goods sold, which represented a much larger percentage of costs at the lower sales volume, as well as product mix, pricing and product-cost variation.
- Operating expenses decreased by $322 thousand, primarily due to lower shipping, employee compensation and third-party product-development costs, but the reduction was insufficient to offset the sales decline.
- Operating cash flow fell to $165 thousand from $6.562 million. The current-period cash generation was primarily driven by a $4.608 million reduction in accounts receivable, partly offset by a $3.005 million reduction in accounts payable.
- Accounts receivable declined to $728 thousand from $5.322 million, while accounts payable declined to $1.209 million from $4.214 million.
Guidance, Outlook, Risks and Unusual Items
Management did not provide quantified revenue or earnings guidance. It identified future results as dependent on retaining existing customers, demand for wireless data products, acceptance of new products, new customer relationships and contracts, and the ability to meet customer demand.
- Customer concentration was significant: three customers represented 34%, 34% and 21% of quarterly sales. Two customers represented 60% and 20% of accounts receivable at September 30, 2013.
- Three Asian manufacturers supplied 93% of product purchases during the quarter. Supplier delays, capacity constraints or quality problems could delay shipments or result in canceled orders.
- The company reported no allowance for doubtful accounts or inventory reserve, despite stating that customer demand is unpredictable and inventory may become obsolete or excess.
- The company was involved in ongoing litigation with Novatel Wireless regarding alleged patent infringement. The filing states that any potential loss could not reasonably be estimated.
- A dispute with C-Motech concerns the uncompleted repurchase of 1,566,672 shares, representing approximately 15% of outstanding common stock. The company filed suit seeking damages, specific performance and related relief; the outcome and whether the repurchase will occur were uncertain.
- Change-of-control agreements could require aggregate payments of up to $8 million to three executives upon specified change-of-control events. The agreements expire between September 2014 and September 2015.
- The quarter included a $453 thousand income tax benefit and a corresponding increase in current deferred tax assets. Management recorded no valuation allowance but stated one may be required if the company incurs future taxable losses.
- The company capitalized $139 thousand of product development costs and reported $2.915 million of net intangible assets, including $171.5 thousand of technology in progress.
- Management stated that disclosure controls and procedures were effective at September 30, 2013 and that no material change occurred in internal control over financial reporting.
Investor Verification Checklist
- Verify the causes and persistence of the 89.3% sales decline, including the large customer’s purchasing issues, chipset discontinuation and transition from WiMAX to LTE.
- Assess whether quarterly sales and gross margins can recover sufficiently to support the company’s cost structure and ongoing product-development spending.
- Review customer and supplier concentration, collectability of receivables, inventory exposure and the absence of recorded reserves.
- Confirm liquidity through September 30, 2014 and evaluate the March 2014 maturity and 10.55% rate on the short-term borrowing.
- Monitor the Novatel patent litigation and C-Motech share-repurchase dispute for potential cash costs, ownership changes or dilution-related effects.
- Evaluate the realizability of approximately $1.955 million of current and non-current deferred tax assets, given the reported quarterly loss.