Business Context and Reporting Period
Franklin Wireless Corp. designs, manufactures and sells 3G and 4G wireless data communication products, primarily USB modems and embedded modules, through wireless operators, strategic partners and distributors. The company operates in one reportable segment and serves customers in the United States, the Caribbean, South America and Asia.
This unaudited Form 10-Q covers the three and six months ended December 31, 2011, compared with the corresponding periods ended December 31, 2010. The filing metadata refers to “2011 Q2,” but the reported fiscal period is the quarter ended December 31, 2011 and the first six months of fiscal 2012.
Key Financial Metrics
| Metric | Three months ended Dec. 31, 2011 | Three months ended Dec. 31, 2010 | Six months ended Dec. 31, 2011 | Six months ended Dec. 31, 2010 |
|---|---|---|---|---|
| Net sales | $3.0 million | $15.6 million | $6.1 million | $32.1 million |
| Gross profit | $0.6 million | $6.1 million | $1.4 million | $11.0 million |
| Gross margin | 21.0% | 39.1% | 22.1% | 34.2% |
| Operating income (loss) | $(1.0) million | $3.6 million | $(1.9) million | $5.5 million |
| Net income (loss) | $(0.5) million | $2.0 million | $(0.9) million | $3.2 million |
| Basic EPS | $(0.04) | $0.17 | $(0.08) | $0.25 |
- Six-month selling, general and administrative expense was $3.3 million, down from $5.4 million; however, it represented 53.8% of sales versus 16.9% in the prior-year period.
- Cash provided by operating activities was $3.0 million for the six months, compared with cash used of $0.3 million in the prior-year period.
- Cash used in investing activities was $0.9 million, primarily reflecting $0.9 million of capitalized product development costs.
- Cash provided by financing activities was $0.6 million, including $0.5 million raised by the subsidiary Franklin Technology Inc. through an equity issuance.
- Cash and cash equivalents were $14.1 million at December 31, 2011, compared with $11.4 million at June 30, 2011.
- Total liabilities were $4.1 million, including $0.1 million of short-term bank borrowings and $1.6 million of marketing funds payable. The filing does not identify material long-term debt.
- Total assets were $22.4 million and stockholders’ equity was $18.3 million at December 31, 2011.
Material Changes Versus the Prior Comparable Period
- Six-month sales declined 80.9%, driven by an 80.7% decline in United States sales and a 99.4% decline in Caribbean and South American sales. Asian sales increased 460.2% to $1.6 million, primarily from a new customer purchasing the M600 dual-mode module.
- Management attributed the U.S. decline to increased competition, pressure on volume and pricing, and delays in launching new products because of extended design, testing and certification schedules.
- Caribbean and South American sales were affected by order timing and customers transitioning from CDMA networks to LTE or HSPA+ networks.
- Gross margin declined by 12.1 percentage points for the six-month period, primarily because of customer and product mix.
- The company moved into larger San Diego office space on September 1, 2011. Monthly rent increased from $8,975 to $16,576.
- Accounts receivable declined to $2.2 million from $6.9 million at June 30, 2011, while inventories declined to $0.3 million from $0.9 million. These working-capital reductions were the principal drivers of operating cash flow.
- Capitalized product development costs reached $1.0 million at December 31, 2011, compared with none at December 31, 2010.
- On July 1, 2011, the company purchased a $0.5 million convertible bond issued by FTI and converted it into 916,666 FTI shares. FTI also issued shares to new investors for $0.5 million, resulting in Franklin holding 51.8% of FTI and non-controlling interests holding 48.2%.
- Common shares outstanding decreased to 11,882,971 at December 31, 2011 from 13,781,491 at June 30, 2011, excluding 1,803,684 treasury shares.
Guidance, Outlook, Risks and Unusual Items
- Management did not provide quantitative revenue, earnings or margin guidance. It stated that future revenue will depend on retaining existing customers, demand for wireless data products, acceptance of new products, new customer contracts and the ability to meet customer demand.
- Management stated that cash on hand, operating cash flow, bank lines of credit and potential equity issuance are expected to fund requirements for the next twelve months, although the company continues to invest in product development and has incurred losses.
- Customer concentration is significant: four customers represented 24%, 22%, 18% and 15% of six-month sales. Two Asian manufacturers supplied 89% of purchases, creating supplier concentration and potential shipment, capacity and quality risks.
- The company reported no inventory reserve and no allowance for doubtful accounts. Demand is described as highly unpredictable, creating potential obsolescence and collectability risks.
- The company is disputing the obligation to repurchase an additional 1,566,672 shares from C-Motech for approximately $1.6 million. C-Motech owns approximately 13% of Franklin’s common stock, and the ultimate outcome was not determinable as of the filing date.
- Pending legal matters include patent infringement claims involving Novatel Wireless and Brandywine Communications Technologies, and a fiduciary-duty action against officers and directors. The company believes the matters are without merit or not material, but the Novatel loss cannot currently be estimated.
- Change-of-control agreements provide potential payments of $5 million, $2 million and $1 million to three executives. The agreements were extended, with expiration dates in 2014 and 2015.
- The company recorded income tax benefits of $0.3 million for the quarter and $0.5 million for the six months. Management believes deferred tax assets are realizable but may need a valuation allowance if taxable losses continue.
- Disclosure controls were evaluated as effective at December 31, 2011, and no material change in internal control over financial reporting was reported.
Investor Verification Priorities
- Verify whether the sharp sales decline was temporary and whether delayed product launches, competitive pricing and customer network transitions have been resolved.
- Assess customer concentration, order timing and the sustainability of the new Asian customer relationship.
- Review the recoverability of capitalized development costs and deferred tax assets in light of continuing operating losses.
- Confirm the status and potential cash impact of the unresolved C-Motech share repurchase obligation.
- Track the Novatel, Brandywine and fiduciary-duty proceedings for potential damages, injunctions, indemnification or defense costs.
- Evaluate liquidity after considering recurring operating losses, the March 9, 2012 maturity extension of the $139,134 bank borrowing, lease commitments and any potential equity financing.