It's time to check in on JDS Uniphase (Nasdaq: JDSU), which released earnings for the second quarter of its fiscal year last Thursday. Without merger and other onetime expenses, JDS reported a Q2 operating EPS profit of $0.21, beating Street estimates by $0.02. But the company cut its Q3 projected growth rate in half, to between 7% and 10%. After reading the press release and listening to the conference call, I have to admit that I'm perplexed. From what I've been able to tell (e.g., see this RM article on CLECs), the economic environment for many of the companies that ultimately use JDS' products is difficult.
JDS did admit that there are a couple of issues in its business environment:
- There are some weaknesses in its industry in general;
- Capital expenditures are down;
- Inventory levels are being adjusted; and
- Its visibility into future quarters is more difficult than it has been historically.
This led the company to lower its guidance for the third quarter and also to state its belief that full-year results will come in at the lower end of expectations. However, the JDS management team doesn't believe the present problems will last for more than another quarter or so. As a matter of fact, during the Q&A section of the conference call, management stated its belief that if carriers don't invest in adding capacity and bandwidth, the Internet will end up something like the California electrical market. While the precise timing is not known, JDS believes that money will be spent to expand bandwidth.
It seems unlikely that JDS will have the type of visibility into future results that it's had in the not-too-distant past until the shakeout of telecommunication service providers and carriers is finished. The problem with visibility is also one that Cisco Systems (Nasdaq: CSCO) has been forced to reckon with. While JDS' book-to-bill ratio -- which is an indicator of future results -- remains above one, it's not unreasonable to assume that even carriers as large as AT&T (NYSE: T) and WorldCom (Nasdaq: WCOM) will have to slow down their plans to build and may even cancel some future orders.
As a JDS shareholder, I certainly believe the company will succeed over the long term. I also don't doubt that the demand for bandwidth will eventually need to be met. However, I don't think the available evidence supports the conclusion that things will turn around as quickly as JDS states. They could, but if JDS does meet its short-term growth targets, its balance sheet will likely continue to weaken and the company could continue to have difficulty generating the free cash flow it needs in the short term. This adds to the risks we face as JDS shareholders. It's also why we haven't purchased more shares with our monthly $500 investments, even though the stock price is well off its highs.
Due to the many acquisitions that JDS has made, and the fact that the accounting rules don't force the company to restate its balance sheet for prior periods, I analyze JDS on a quarter-to-quarter rather than year-over-year basis. The dynamic growth of the company's business also allows for this approach, as it essentially overcomes any effects of seasonality.
In four of the last five quarters, JDS has seen its accounts receivable balance grow more rapidly than its revenues. That's something we never like to see. While Days Sales Outstanding -- Accounts receivable / (Sales / 90) -- has remained relatively flat during the past five quarters, this is still a disturbing trend. In addition, JDS's Foolish Flow Ratio has increased from 1.54 to 1.87 over the same period. JDS is also taking more time to sell its inventory, and its cash conversion cycle shows that it is now taking more time to turn its purchased raw materials into cash.
I apologize for just throwing a bunch of ratios at you, so let's step back and take a look at why they should give an investor pause.
Not every customer pays its receivables. Sad but true, there are some deadbeats out there. It took JDS four days longer (61 days) to collect from its customers this quarter than last quarter. If that trend continues and receivables continue to grow faster than revenues, there's a greater risk JDS won't be able to collect from all its customers.
The products that JDS sells can change rapidly. The longer JDS' inventory sits on its shelves, the greater the risk that there will be spoilage. That's wasted money.
Cash conversion cycle (CCC)
The elements of the CCC are the key components of a company's working capital (i.e., current assets and current liabilities). Failure to keep the CCC under control results in a decrement in the company's cash flow from operations (CFO). If a company can't generate enough CFO to fund the cost of any tangible assets it needs to expand its business, ultimately it will have to borrow money to fund its needs. (Did you catch that? If not, you owe it to yourself to read our classic explanation of how cash moves through a company, Tying It All Together With the Flow Ratio.)
In addition, the value of a company comes down to its ability to generate cash from operations. Inefficient working capital management leads to the company being accorded a lower valuation.
In difficult times, there can also be advantages gained from working with customers to keep their business. To a certain extent, JDS may have to walk a fine line here in maintaining customer relationships. The risk is that if JDS requires overly tough payment terms of a customer now, and that customer is ultimately successful, it may be less willing to do business with JDS in the future. This means that JDS should step up any due diligence it does with regards to its customers. If the customer looks poised to succeed over the long term, then JDS' treatment of that customer should be different than it would be for a customer with, say, a balance sheet that's hemorrhaging debt.
Have a great day.
Phil Weiss, TMF Grape on the Discussion Boards
Phil Weiss, his family of four and their two dogs live peacefully in New Jersey. At the time of publication he owned shares of both JDS Uniphase and Cisco Systems. You can see his other stock holdings on his profile page. The Motley Fool is investors writing for investors.