Business Context and Reporting Period
Franklin Wireless Corp. designs, manufactures and sells 3G and 4G wireless modules and modems, primarily USB broadband modems, through wireless operators, strategic partners and distributors. The unaudited Form 10-Q covers the three months ended September 30, 2012, the first quarter of fiscal 2013, with comparison to the three months ended September 30, 2011.
Financial Performance and Position
| Metric | Q1 FY2013 | Q1 FY2012 |
|---|---|---|
| Net sales | $13.14 million | $3.12 million |
| Gross profit | $3.18 million | $0.56 million |
| Gross margin | 24.2% | 17.9% |
| Operating income (loss) | $1.26 million | $(0.94) million |
| Net income (loss) | $0.64 million | $(0.73) million |
| Net income (loss) attributable to parent | $0.74 million | $(0.45) million |
| Basic and diluted EPS | $0.06 | $(0.04) |
| Cash flow from operating activities | $6.56 million | $2.89 million |
Operating expenses were $1.92 million, or 14.6% of sales, compared with $1.50 million, or 47.9% of sales, in the prior-year quarter. Income tax expense was $564,000, compared with a $176,000 tax benefit previously.
Cash and cash equivalents were $12.85 million at September 30, 2012, compared with $9.42 million at June 30, 2012. Total current assets were $19.71 million and current liabilities were $8.62 million, indicating approximately $11.09 million of reported working capital. Accounts receivable declined to $3.76 million from $13.22 million, while inventory declined to $1.61 million from $1.75 million.
Total debt consisted primarily of $139,134 of short-term bank borrowings, extended to March 2013 at a 7.36% interest rate. Total liabilities were $8.62 million and stockholders’ equity was $17.19 million at September 30, 2012.
Investing cash outflows were $708,005, including $340,813 of capitalized product development costs and $186,523 of intangible-asset purchases. Financing cash outflows were $2.41 million, primarily for the repurchase of 1,538,602 common shares. The company reported no off-balance-sheet arrangements.
Material Changes Versus the Prior Comparable Period
- Sales increased $10.01 million, or 320.6%, primarily from new products and new U.S. customers.
- U.S. sales increased 402.5% to $11.95 million and represented 91.0% of total sales. Caribbean and South American sales increased to $746,300, while Asian sales declined 37.9% to $438,686.
- Gross margin expanded by 6.3 percentage points, reflecting changes in customer and product mix, selling prices and product costs.
- The company returned to operating and net profitability, despite higher operating expenses, research and development costs and share-based compensation.
- Operating cash flow increased by $3.68 million, supported substantially by a $9.46 million reduction in accounts receivable and a $4.39 million reduction in accounts payable.
- The company repurchased the Sherman Group’s 1,538,602 shares for $2.83 million, or $1.84 per share, including a $440,000 premium previously recorded in operating expenses and a $15,386 commission charged to capital.
- Intangible assets increased to $3.66 million from $3.52 million. Amortization expense increased to $377,937 from $210,359.
Guidance, Outlook, Risks, Contingencies and Unusual Items
No quantitative revenue, earnings or cash-flow guidance was provided. Management identified revenue drivers as retaining existing customers, demand for wireless data products, acceptance of new products, new customer contracts and the ability to meet customer demand.
- Customer concentration is significant: two customers represented 50% and 34% of quarterly sales and 38% and 20% of accounts receivable, respectively.
- One Asian manufacturer supplied $8.00 million, or 83.4%, of quarterly product purchases and was owed $3.93 million at September 30, 2012. Manufacturing delays, capacity constraints or quality issues could materially affect shipments and revenue.
- Demand is described as unpredictable, creating potential inventory-obsolescence and excess-inventory risk; no inventory reserve was recorded.
- The company has not completed the planned repurchase of 1,566,672 shares from C-Motech for the remaining $1.63 million balance. C-Motech owns approximately 15% of the company, and the outcome of the obligation remains uncertain.
- Patent litigation brought by Novatel Wireless remains pending. The company stated that any potential loss could not reasonably be estimated and that it intends to defend the matter. A separate patent matter involving a customer and a company-supplied device was also pending but was not expected to have a material effect.
- The Sherman Group fiduciary-duty litigation was dismissed with prejudice after the September 2012 repurchase and settlement agreements.
- Change-of-control agreements could require payments of $5 million, $2 million and $1 million to three executives upon specified change-of-control events.
- Management concluded that disclosure controls and procedures were effective as of September 30, 2012 and reported no material change in internal control over financial reporting.
Important Facts for Investors to Verify
- Whether the sharp sales increase is sustainable or reflects timing of orders, new-customer launches and product mix.
- The identity and continuing purchasing plans of the two customers representing 84% of quarterly sales.
- Collection of the remaining $3.76 million of accounts receivable and the sustainability of the quarter’s operating cash flow.
- The status and financial impact of the unresolved C-Motech share-repurchase obligation.
- The potential exposure and insurance or supplier indemnification related to pending patent litigation.
- The recoverability of $3.66 million of intangible assets, including capitalized development costs, certifications and licenses.
- The company’s ability to manage reliance on one principal Asian manufacturer and its concentration of cash deposits above FDIC-insured limits.