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Excellent post. Thanks for going through the numbers. I had not calculated the non-SCSS revenue numbers and it is useful information to lay it out as you have.
One concern I have, which I believe is shared by others and is part of the cause for the price drop, is that the 3rd quarter gp decreased to 23%. This was both less than the prior year 3rd quarter and the first 6 months. I had anticipated the margins to widen as revenues increased but with a small company it's sometimes tough to predict. Nonetheless, I am uncomfortable with assuming that the margins will be higher going forward. Also, assuming they keep some SCSS business beyond the first half of 2006, the renegotiated contract will likely put more pressure on the margins. Also, if they have less SCSS business my assumption is that it will be a few years (3-4 seems a reasonable guess) before they can fully replace this revenue even if they keep up the recent growth you have illustrated. During this time, WEX will have less revenue to cover overhead costs and this too, will put pressure on the margins.
Best case - WEX retains SCSS business of at least 80% of current level and growth elsewhere more than offsets modest loss of SCSS business. Margins stay healthy as overhead costs are more easily absorbed by increased revenue base. Other costs are lower, like sarbanes oxley. GP margin holds steady or expands... investors regain confidence as the SCSS cloud of uncertainty dissipates... the pe awarded to WEX expands to a more normal level (say 10 - 12) and the stock price easily moves above $6 and continues towards double-digit heaven over a couple of years with continued growth and profits.
Worst case... they lose the SCSS business altogether and it takes years to replace with new customers. During the first year or two after the loss of SCSS WEX bleeds red as it doesn't have enough revenue to cover overhead or has to restructure to adjust for the smaller size and takes substantial one-time hits. Note that I disagree with someone who previously posted who adjusted profits just based on the % of SCSS revenue. I think if you lose all of the SCSS revenue, you break the streak of profitable quarters that Lorin is rightly proud about.
I'm still long. I sold half my holdings at $6.20 and bought back prematurely at $5.10. I am tempted to average down at this point, but there are significant risks and I don't see the clouds of uncertainly clearing before March or April at the soonest. Would be nice to see another PR illustrating more new growth from outside SCSS.
Luck to all. Thanks again to Monty for the quality post.
(continued from previous)
5. Winland has been increasing it's design services business and therefore, it is possible they are taking on more staff to cope with that aspect of the business. This type of work always has a substantial lead time to get a return. Therefore it is reasonable to think that costs such as salaries have been incurred in advance of billings. The notes to the accounts imply that billings are in arrears therefore revenue might easily have been deferred to a subsequent billing while the costs are picked up as the work is performed.
6. In the September quarter Winland introduced production for 24 new OEM products. This was almost half the total (56) for the whole year. That indicates to me that there may have been a lot more preparatory work in the 3rd quarter than in other quarters and costs were brought to account.
In summary, therefore, I took the view that given the various reasonable possible explanations for the modest variation in GP it did not appear significant enough to draw a conclusion that the profitability of the new sales was falling. In the absence of better information, one quarter is just too short a period to draw a definitive opinion. I could be wrong. Perhaps other posters who have better knowledge of the company's particular circumstances could point out the errors in my foregoing assumptions. I will then stand corrected.
I would add one other point alluded to by other posters and that is the increased remuneration just posted together with the gradual dilution of the stock over time. Politically it is always difficult to identify a time when such increases should be taken. However, I would personally prefer that proper levels of salaries are paid to ensure that the best possible people available for the job can be attracted and adequately rewarded. Furthermore, I would prefer to pay salaries and minimize dilution of capital. Again time will tell whether the management is good enough to do the work in front of them. Until then we speculate.
Finally I apologize for being a little expansive.
Thanks for the observations. I did look at the quarter on quarter comparisons but did not consider the difference significant. These are my reasons:
Net Sales Gross Profit %
3rd q 2005 7,399,885 1,699,273 22.96
3rd q 2004 6,613,692 1,534396 23.20
It is perfectly true that the 3rd quarter 2005 saw a slight drop in GP margin. However, if you calculate how much additional margin was needed to equal last years percentage, the answer is $17,522.
When I saw that I concluded that in the context of a manufacturing enterprise of the type conducted by Winland, comparing one quarter to another is possibly too short a period to make a reasonable comparison for the following reasons:
1. If one looks at the notes to the accounts, the following items were cited by the company as affecting the GP in the quarter:
Increased salary and related expenses $74,053
Increased warranty costs $23,635
Increased obsolescence $15,323
There is no explanation for the increases in these items but in the context of manufacturing and in the absence of any other information they are the day to day ebb and flow of business and in particular the salary costs are easily understood in the context of the matters noted below.
2. Winland had announced that they had 2 new contracts and that deliveries had already begun. I don't know anything about this particular business but I know enough about manufacturing that when one wins a new contract there are set up costs which will effect the GP. This business seems a lot more intricate than the businesses I am involved in but in any case I took the view that an additional cost of $17,522 could easily be incurred by any number of means when setting up the production line for a new product. A lot of the manufacturing equipment of Winland would be computerized. Have you ever had to adjust or modify a computer program for a new configuration and done so without a glitch? From my experience a few programming engineers working on one software package for a single new configuration could run up a bill of $20,000 before the water boils for their morning tea!
3. I don't know how that accounting rules would apply in this instance, but again, I suspect that in winning the contract from Cardiac Sciences, there would have been a lot of costs and testing for variances, tolerances, product configurations to satisfy their own stringent requirements. Again, it is not possible to know if these costs were incurred just in this period, but it is certainly a revenue cost which would be borne by Winland in trying to win the contract. Certainly part of the increase in salaries could be explained by this work.
4. The press release concerning the contract with the undisclosed party indicates that there are proprietary elements to the products. Furthermore it indicates that prototypes are being developed. Again I don't know the accounting treatment but it seems that in any case, even if there was a requirement to capture development costs and capitalize them, it is impossible to do it accurately. In any case, the tooling up and the labor requirement would have increased cost of sales.
(to be continued)