The Oscars will be held later this month, and it's a good bet that Avid Technology's (NASDAQ:AVID) digital magic played more than a minor role in making each of the film nominees a success. It's also a good bet that it's going to take more than pixel dust if Avid ever hopes to receive another standing ovation from Wall Street. The company needs to make some operational changes, and fast.
Following on the heels of a challenging third quarter, Avid closed out fiscal 2006 with another subpar performance. In this edition of Fool on Call, with the aid of the company's latest quarterly earnings conference call, we'll obtain better clarity on what challenge it's facing and how it hopes to right the ship in 2007.
A bottleneck in the pipeline
For the fourth quarter, net sales came in at $239 million, shy of the $245 million mark it achieved this time last year. Both revenues and operating profits were negatively influenced by continued challenges in its video division.
In his prepared remarks, outgoing CFO Paul Milbury blamed the challenges on a lack of "customer acceptance on several large broadcast deals." He adds, "And we were unable, for operational reasons, to move as many deals as we had expected from backlog to revenue."
The softer top line was one reason for the weaker-than-expected profitability. Excluding one-time non-cash charges, Milbury indicated that gross margins "would have been 50.2%," which is nearly a full percentage point higher than the same period a year ago but lower than what management was anticipating. As one might expect, the primary reason for the shortfall is that video gross margins were "down substantially."
It's in the margin discussion where we start to find the heart of the problem. Because of the Pinnacle acquisition, margins were negatively affected by less profitable deals associated with Time Warner's (NYSE:TWX) CNN, which Avid had to eat when it purchased Pinnacle. Avid was well aware, prior to its purchase, that Pinnacle is generally less profitable, so this mention should come as no surprise to management. What should raise eyebrows is the other reason it offered for weaker profitability: "Margins were lower due to lower service revenue on a relatively fixed basis."
The reason that lower service revenue is a concern is that service was supposed to be one of the company's key initiatives to address one of its most glaring problems over the past year: inconsistency in its revenue recognition. As we found last quarter, the ever-increasing size and complexity of HD broadcast projects has made it more difficult for the company to capitalize on opportunities.
In response, Avid reorganized its management structure to put an emphasis on service, as this was thought to be the best solution not only to get projects moving, but also to provide a way to further capitalize on existing contracts. What we're learning now is that the service approach hasn't taken hold as planned, creating further bottlenecks in translating backlog into revenue.
Addressing the bottleneck
If there's a silver lining here, it's that video ended "the year with its highest backlog ever, more than twice the amount that it had at the end of 2005." The question is whether Avid can address its service shortfalls to capitalize on projects on a more consistent basis.
CEO David Krall states, "There are a number of initiatives underway to help, although there is no single fix to the entire issue." One step the company has taken is that a new team was created within the video division, ensuring that Avid products headed to these large projects "are clearly identified and tracked." A separate "worldwide enterprise team" was established that will look to "improve the uniformity of solutions" across the various regions, which is then expected to lead to greater "predictability of delivery."
Additionally, compensation packages have been retooled to emphasize selling products that are currently available for delivery. And finally, Avid is looking at present business practices that currently do not permit recognition of revenue until projects are completed, looking to see if there's a way to begin recognizing revenue as services are rendered. Though this would likely improve revenue forecasting, investors should be aware that such an accounting change wouldn't speak to an improvement in the quality or value of its business functions.
So the big question is, how long will it take to get things going in the right direction again? Milbury states, "We currently expect it to take at least another quarter to get beyond some of the video issues." By the second quarter, the company expects "to see the benefits of the positive changes" in its video segment. As such, the company anticipates Q2 revenue and earnings per share to "increase substantially" from Q1. For the full year, the company is looking for top- and bottom-line growth of 8% to 10%.
Don't get punk'd!
Viacom's (NYSE:VIA) hit show Punk'd, from its MTV Networks, recently revamped its video editing software with Avid products. Punk'd editor Miles Barken states, "For these kinds of shows we need a forklift, not a gurney -- and Avid is the way to go."
Similarly, the major broadcasters -- CBS (NYSE:CBS), General Electric's (NYSE:GE) NBC, and Disney's (NYSE:DIS) ABC -- are also finding that Avid is the way to go as the industry shifts to an HD format. Business is indeed brisk for Avid Technology, as indicated by a record backlog.
But can the company's new plans begin to translate a record backlog into record profits? Given management's remarks, it's plausible, and it certainly sounds better than the alternative -- getting punk'd ... twice.
Disney and Time Warner are Stock Advisor picks.
Fool contributor Jeremy MacNealy has no financial interest in any company mentioned. The Motley Fool has a disclosure policy.
