Omnivision Technology
Will the Real Margins Please Stand Up...

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By zoningfool
December 5, 2006

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If you read the 10-Q's and 10-K's filed by Omnivision, read the earnings releases or listen to the cc's, you will notice that there are a number of line items which obfuscate the true picture on Omnivision's margins. What's particularly disturbing is that in the pro forma numbers, Omnivision adds back-in to income the stock-based compensation and one-off expenses such as litigation settlements, yet it does not back-out the sales attributable to previously written-off inventory or payments from suppliers over quality issues. For example, in the latest earnings release dated 11/30/06, I note that the Pro Forma income statement reconciliation did not back-out the benefits of the $1.6M received from a supplier or the impact of sales of $4.1M in previously written-off inventory.

This is what the earning release stated:

During the quarter, the Company recognized the benefit of $1.6 million of compensation from a supplier whose product quality in previous periods did not meet the Company's quality standards. In the prior period, gross profit included $2.2 million for similar issues....

.... During the quarter, the Company accrued a $3.3 million expense for its share of the probable settlement of the class-action securities litigation originally filed in mid-2004.

From the earnings cc (courtesy of

Quinn Bolton - Needham & Company

Okay. The second question for Peter, Peter, in the past three quarters, you have given us the benefit of previously written down inventory and then also the amount of newly written down inventory in the quarter. I was just wondering if you had those figures.

Peter V. Leigh

I do, if you will give me one second. I think that the sales of previously reversed inventory in the quarter was $4.1 million, and we booked about $1.5 million of new reserves.

However, in the pro forma numbers, Omnivision added the $3.3M settlement expense back into income, but did not subtract out the $1.6M supplier compensation benefit or the $4.1M benefit of selling essentially costless inventory.

In addition to this rather selective choice as to what to leave out of the pro forma numbers, there are discrepancies between the information in the 10-Q's and 10-K's. For example, this is from the 10-Q filed on 12/10/04 for Q2 2005:

For the three months ended October 31, 2004, an additional approximately $3.5 million of gross profit was attributable to the sale of inventory which had been substantially reserved in prior periods

Yet, the 10-Q filed on 12/09/05 for Q2 2006 states this about the Q2 2005 period:

In the three months ended October 31, 2005, revenues from the sale of previously reserved products were $0.8 million, as compared to $5.5 million in the prior year period.

In the 10-Q filed on 3/14/05 for Q3 2005, it states

Our gross margins for the three and nine months ended January 31, 2005 were adversely impacted by approximately $2.8 million in additional provisions related to the possible replacement of product which did not meet a particular customer's specifications.

Yet, in the 10-K filed for FY 2005 on 7/14/05, it states:

Our gross margins in fiscal 2005 were adversely impacted by approximately $1.3 million in additional provisions related to the possible replacement of product which did not meet a particular customer's specifications

Confusing to say the least.

Trying to sort through the confusion, I created my own pro forma numbers for Omnivision--numbers which include all relevant line items, not just the ones that improve results. Complicating the matter is the advent and implementation of FASB Statement 123R which mandates expensing of stock options on the income statement--until recently, this expense needed only to be reported in the footnotes.

The company, according to its SEC filings--the 10-Q's, uses a modified prospective approach with respect to S123R. This method makes apples-to-apples comparisons difficult since the company does not include stock-based compensation in the year-ago numbers. S123R became effective for Omnivision in Q1 2007. Quarters prior to that exclude stock-based compensation expenses from the gross, operating and net profit figures. For accurate comparison purposes, we need to either back-out that compensation from past periods or add-in the expense to periods after which 123R took effect. Given that the breakdown is not provided for stock-based compensation in pre-123R periods (during which companies were merely required to report an aggregated expense in the footnotes), we will need to use the later option to obtain truly comparable results for gross and operating margins.

In calculating these numbers, I am using the most recent data available. Therefore, for the quarter ended October 2004, I used the more recent number of $5.5M for written-off inventory. For the quarter ended February 2005, I used the $1.3M for provisions for product replacement. The rationale for using the latest data is that hindsight is 20/20 and over time, more information becomes available, presumably making more recent data more accurate.

To arrive at a more accurate picture of Omnivision's margins, from gross, operating, and/or net income, I added back-in stock based compensation and extraordinary expenses and cost of previously written-off inventory sold during the quarter, and subtracted extraordinary benefits. I then calculated gross, operating and net margins accordingly.

Here are the results:

[See post for chart.]

As you could see, in addition to the profit and margins being lower than reported, the deterioration is worse than we thought. Now, this of course is a backwards-looking exercise. However, unless there is a tangible turnaround in cost structure, product mix, ASP's, or product development timetables (WFC is apparently still not ready for prime-time), this is a company whose stock one should be careful in scooping-up just yet. This company may not be the value play it appears to be.

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