Monday, June 1, 2009

Channel Stuffing or Poor Predicting?

A reader recently pointed out the fact that LoJack (LOJN) appears to be "channel stuffing" its international sales. What exactly is "channel stuffing" and how does one detect whether it's taking place?

Channel stuffing is the practice of selling more products to one's customers than the customers can sell to their customers. (For a more detailed description, see here.) In the short-term, this can increase sales (and therefore profits), but it can't be sustained forever since the customer's inventories will continue to bloat until there is finally a day of reckoning.

To determine whether a company in which you are considering investing is stuffing its channels, the first stop is the revenue recognition note to the financial statements. For example, here is what LoJack has to say about how it recognizes revenues from international customers:

Revenue relating to sales to our third party installation partners is recognized upon shipment, which is prior to the installation of the related products in the consumer’s vehicle. Revenue from the sales of products and components of the LoJack System to international licensees is recognized upon shipment to the licensee or when payment becomes reasonably assured.

Basically, LoJack recognizes a sale once it has shipped the product to its international 'licensee', or customer. While this is not the most conservative method of accounting (since the product has not actually been installed in anyone's vehicle at the time the sale is recognized), it is not all that unusual.

The next step we would take is to compare the number of units shipped to the licensees over the years to the number of end-customer installations the licensees have actually performed. This would give us a good idea of what licensee inventory looks like, and we used a similar analysis to view the channel stuffing status of Harley-Davidson with respect to its dealer network. Unfortunately, LoJack does not provide such numbers.

But that doesn't mean our journey ends there. Another useful indicator of channel stuffing is whether the company's receivables account has been growing at a disproportionate rate. If the company is enticing customers to "purchase" products by offering generous financing (i.e. "Just accept delivery, you can worry about paying us later!"), it will show up here.

In LoJack's case, there is enough disclosure to determine that at least $22 million of its year-end 2008 A/R is owed by international licensees, compared to 2008 international sales of $64 million. This represents a long 128 days between when a customer receives the product and when it pays for it, compared to a much shorter 90 day period when using the comparable numbers from 2007.

While this may look like damning evidence, investors must keep in mind that international customers represented just 15% of last quarter's sales. Furthermore, this situation appears to be correcting already: as per LoJack's latest results, international sales fell 61% versus the year-ago period. It would appear that international customers are paring down inventory, as it is unlikely that end-consumer installations fell by such a large amount. Furthermore, we only have a snapshot of receivables at one point in time; if an abnormally large shipment was received in the days before the year-end, the numbers we use don't tell us the full story.

With the following line, LoJack also hints that poor predictions by its international customers had them ordering far more products than they needed:

Our international unit volume and revenue reflect...the effects of a build-up of inventory at the end of 2008 by certain licensees in anticipation of better economic conditions during 2009. The economic uncertainty in the international markets has impacted the buying patterns of our licensees, as they work to...minimize inventory.

The bottom line in all this? As usual, it's hard to know for sure. By objectively considering the issues discussed, investors should make up their own minds as to whether something fishy is going on, or whether the economic slowdown that occurred last quarter caught some customers off-guard. 

For a discussion of LoJack as a possible value investment, see this article.

Disclosure: Author has a long position in shares of LOJN


Anonymous said...

Excellent analysis.

I would want to distinguish intentional channel stuffing with the aim to mislead from what looks to be the case here--namely, mistaken projections by international customers.

So in a strict sense, their international supply channels appear 'stuffed', and international sales will likely be lower in the future. If you have sufficient margin of safety, I wouldn't think this change would irreparably harm the investment thesis.

PlanMaestro said...

Barel, it is a pleasure to follow your posts and your openness to criticism and suggestions is commendable.

Looks like this Q is going to be critical: The Mexican economy has been hit the last 2Qs. At the same time it looks like they are streaming the channel inventory. If there is a substantial fall in international sales it could be the time to buck up the truck.

Saj Karsan said...

Hi Guys,

Thanks for the kind words!

PlanMaestro, I'd also like to see some sort of settlement on the Chinese lawsuit (though that may be wishful thinking), so that I have more confidence in my valuation.