DESWELL INDUSTRIES INC annual report, Q4 FY2018

Business context and reporting period

Deswell Industries, Inc. filed this audited Form 20-F for the fiscal year ended March 31, 2018. It manufactures injection-molded plastic parts and electronic products and assemblies in Dongguan, China. The filing is an annual report, not a fiscal 2017 Q4 filing; it provides semiannual results for fiscal 2018, but no standalone Q4 results. Amounts below are U.S. dollars unless stated otherwise.

Financial results and liquidity

• Sales rose 36.3%: plastics increased $4.971 million and electronics increased $11.174 million. Segment sales were $28.609 million for plastics and $32.512 million for electronics.
• Gross margin fell from 16.7% to 16.0%. Plastics margin declined to 19.4% from 21.4%, attributed mainly to RMB appreciation and higher raw-material costs; electronics margin improved to 13.1% from 11.6%, reflecting labor and overhead controls.
• Net income included $4.395 million of non-operating income, including marketable-securities gains, dividends and rental income. The filing identifies $1.401 million of unrealized gains and $609,000 of realized gains on marketable securities, as well as $1.111 million of rental income.
• At March 31, 2018, working capital was $50.560 million, total current assets $68.905 million and current liabilities $18.345 million. Cash and cash equivalents were $15.192 million; marketable securities were $17.282 million. The company reported no short- or long-term debt and no committed credit facilities.
• Total assets were $100.399 million and shareholders’ equity was $81.279 million. Dividends paid in fiscal 2018 totaled $1.112 million, or $0.07 per share. A further $0.04-per-share dividend was declared in June 2018 and paid in July.
• Fiscal 2018 second-half results were sales of $30.908 million, gross profit of $3.893 million, operating income of $217,000 and net income of $2.521 million. These are six-month figures, not Q4 figures.

Material changes versus the prior year

After nearly flat sales in fiscal 2017, sales rebounded sharply in fiscal 2018, led by professional audio products and increased plastics orders. The company returned to operating profitability and generated positive operating cash flow. Net income growth also reflected higher non-operating income, so it exceeded the improvement in operating performance. Operating cash flow benefited from higher accounts payable, which rose $3.444 million; accounts receivable and inventory increased $2.079 million and $2.541 million, respectively.

Outlook, commentary and risks

• No specific revenue or earnings guidance is provided. Management expects working-capital needs to grow with the business and expects cash on hand and internally generated funds to fund working capital and capital additions; additional financing could be considered if appropriate and available on reasonable terms.
• Management cited cost pressure from labor, raw materials and RMB appreciation, as well as competitive pricing. Plastics margin was particularly affected by currency and materials costs.
• Customer concentration is significant: four customers each exceeded 10% of fiscal 2018 sales and together accounted for 46.3%. Sales are purchase-order based, with no long-term customer contracts.
• Other prominent risks include dependence on China-based manufacturing, customer and supplier credit, electronic-component shortages and turnkey inventory exposure, marketable-securities price volatility, and limits on dividend repatriation under PRC rules.
• The filing says Deswell believed it was a PFIC for fiscal 2018, potentially creating adverse U.S. tax consequences for U.S. investors. It also discusses proposed U.S.–China tariffs as an evolving risk after the fiscal year-end.
• Management concluded disclosure controls and internal control over financial reporting were effective as of March 31, 2018. The independent auditor gave an unqualified opinion on the financial statements but did not opine on internal-control effectiveness; the filing also notes that the China-based auditor was not then subject to PCAOB inspection.
• The board expected semiannual cash dividends, but future dividends remain discretionary and subject to earnings, cash needs and PRC restrictions. No material legal proceedings or off-balance-sheet financing arrangements were reported.

Important facts for investors to verify

1. Obtain quarterly filings or other company disclosures for standalone fiscal 2018 Q4 results; this Form 20-F does not provide them.
2. Assess whether the fiscal 2018 sales increase and operating turnaround are sustainable, including segment demand, gross margins and customer concentration.
3. Separate recurring operating performance from securities gains, dividend income and rental income; review the composition and valuation risk of the $17.282 million securities portfolio.
4. Review cash conversion and working-capital trends, especially receivables, inventory, payables and customer credit quality.
5. Consult tax advisers regarding the company’s stated PFIC status and assess restrictions on upstreaming PRC subsidiary funds and paying dividends.