Omnivision Technology
Cash Flow Statement for OVTI

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By dilettantedude
October 4, 2006

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When I have questions about a company's ability to generate a cash return on my investment, I generally go to the Statement of Cash Flows. After all, ultimately the company is valued on discounted cash flows. EPS for any public company is so much smoke and mirrors, and anyone who says they don't manipulate EPS is simply lying. Discounted free cash flow is bedrock financial theory for calculating fair value, it's the way bond investors calculate the value of a bond, and it's the gold standard. If you can use it, it's the only way to go.

So, perusing the Cash From Operations section of the Statement of Cash Flows, which is the important part of the statement that tells us if the company really is making money on their basic business, I find that in the last quarter CFO was $18.8m vs. $34m 1 year ago. Okay, that's a volatile number quarter-to-quarter. Why is it so low compared with a year ago?

Mostly, it's due to a rebuild in new inventory of unfinished goods, not a big accumulation of obsolete inventory, which you don't want to see for a tech company anyway.

Herb Greenberg was also right. Start with $15.9m in earnings. They paid out nearly $6.5m in stock-based compensation for the quarter, vs. none a year ago. That's added to the $15.9m earnings because it isn't a cash expense, and increases CFO by $6.5m, because it was subtracted as an expense to get net earnings to begin with.

Virtually all the other major items are even more negative, though. Accounts Receivable was a negative $6.1m, reducing CFO by that amount. This was because they had a big increase in sales from last year's inventory build (now obsolete), and haven't collected on all of it yet. Assuming they do collect after allowances for uncollectible accounts (already set aside), this will reverse next quarter, greatly increasing CFO. Last year it was positive $5.2m, for a net difference in CFO of $11.3m just from Accts Receivable!

Subtract another negative $13.6m in inventory build, compared with a much smaller negative $3.0m last year. This reduces CFO vs. last year by another $11.6m. Now we're up to a reduction relative to year-ago CFO of almost $23m, purely for legitimate, short term variations in business operations.

They overpaid on expenses by $3.1m vs. an overpay of $1.3m last year, further depressing CFO relative to one year ago by another $1.8m.

That's pretty much the whole story. Accounts payable add another million or so less to CFO relative to a year ago. Other accruals, income taxes, deferred income and so forth pretty much offset each other as a group.

Bottom line, uncollected sales from the last big product cycle, plus a big inventory build in anticipation of a major new product/sales cycle has temporarily cut cash income during the quarter, far more than offsetting the $6.2m contribution to CFO from the non-cash stock compensation.

If I assume this inventory rebuild reverses by next year, we should be looking at CFO of at least $24m more than this quarter, or about $43m even if earnings haven't grown at all. This should create a big increase in fair value for the stock.

This is normal for companies, especially companies in rapidly changing manufacturing sectors such as high tech. They routinely have big inventory write-offs because of rapid obsolescence. They routinely have big new inventory builds and temporarily lower EPS and cash flow until inventory can be translated into sales. They routinely go through cycles of falling margins, then new rising margins, as inventory obsolesces and is replaced with new, more expensive inventory. Doh. Intel and AMD do this all the time, and have since time began.

I have to assume from the discussion in the footnotes and the evidence of my own analysis of the cash flow statement that they are drawing down cash in anticipation of a big new sales push for one or more major new products. This gets me excited. It also meshes with what the company is telling investors. Plus, it's happened before. We see the same rapid obsolescence cycle in the computer video card business. It doesn't mean a company can't make lots of money, but you have to understand the cycle.

Line items like this in the statement of cash flows are transparent. They reverse typically within a quarter or two. Companies don't go through a big new inventory build just to sit on it. I expect these negative but normal business investment line items to reverse within a couple of quarters, driven presumably by the holiday selling season at the end of the year. The reversal will turn into sales, which will then again turn into cash.

Assuming OVTI hasn't completely lost it, and I certainly see no evidence that they have, this looks to me to be about as close to the bottom of one of these product/inventory cycles as anyone can call it. Sure, the price might drop some more. Sure, there may be some hidden problem no one has ferreted out yet.

That's why one buys stocks like this at a huge discount to fair value based on DCF analysis. The rapid technology cycle makes them risky. They aren't long term investments. But frankly, OVTI generates far more cash than most tech companies. They generate the kinds of cash and ROICs typically seen only in software and similar businesses. This is a hell of a tech company.

I'm assuming a significant drop (temporary) in free cash flow this year, and no growth in free cash flow ever again in history, and discounting this using a higher discount rate than I normally use due to the riskiness of the business, gets me an estimated fair value of $27/share.

This is more than enough of a safety margin for me. I owned the stock once before cheap, got out at around $30 for a profit of over 100%, and have simply been waiting for the cycle to repeat. I don't own it again yet, but all I'm waiting for (barring some unexpected bad news) is for momentum and technical signals to stop being negative.

Sorry for the long post, guys, but some explanation was in order. I hope it helps you make a decision. Going through all this explanation certainly helped me! :)

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