March 20, 2012

International Rectifier may need to rectify earnings

by Sridharan Raman

Semiconductors are the backbone of the electronic revolution, used in everything from cars and computers to refrigerators and mobile phones. Given that demand for semiconductors continues to rise as a range of industries continue to find more diverse applications for them, it’s not surprising that the semiconductor industry has become hyper-competitive. There are 60 semiconductor-related companies with a market capitalization in excess of $1billion trading in the United States alone. Among them is International Rectifier Corp. (IRF.N), which appears to be among the losers within this group, at least as far as earnings quality is concerned: The StarMine research team has identified the company as one whose earnings may not be sustainable in future, thanks to its StarMine Earnings Quality (EQ) model score of only 8.

StarMine uses computer-driven models to analyze the financial statements calculate a proprietary StarMine Earnings Quality (EQ) scores for each publicly traded company. Those companies recording the lowest StarMine EQ scores (on a scale of 1 to 100) are those the model has identified as being the least likely to be able to sustain their earnings. (For a more detailed explanation of this model, please refer back to this recent look at American Express.) In this series, the StarMine research group is examining a handful of North American companies that rank either especially high or low by our quantitative earnings quality measure.

A glance at the chart below shows that inventory levels have been climbing steadily at International Rectifier over the past three years. Most troubling: the number of inventory days spiked to 210 in the last quarter. That kind of buildup in inventory isn’t so worrying if it is caused by an increase in raw materials; that may indicate that the company is gearing up for a new product cycle. However, as can be seen in the 10-Q, filed with the SEC on February 3rd, the rise in inventory days at International Rectifier is a function of an increase in the level of finished goods in inventory, which increased from $76 million in June 2011 to $114 million by December. Such a surge in finished goods inventory levels could be worrying in the semiconductors industry, in which products typically have short life cycles and the risk of obsolescence is high. In the same 10-Q filing, management blamed weak demand for the high inventories in the quarter that ended December 25. They acknowledged that this increase in inventory is not ideal and added that they expect to operate the company’s factories at “abnormally low utilization levels” in the first six months of 2012 in order to reduce inventory levels. That, however, will adversely affect the company’s gross margin.

Source: Thomson ONE / StarMine

The capital expenditures (CapEx) chart below shows that in the past two years CapEx (represented by blue bars) had been on the rise. In spite of a modest decline in CapEx in the last two quarters, it is still higher than the cash flow from operations (represented by yellow bars in the chart below). Capital expenditures not funded by cash flow from operations aren’t usually sustainable and often lead to low earnings quality. Given that the capital spending likely contributed to International Rectifier’s increased production capacity, it seems as if this is back to haunt the business in several respects, ranging from lower margins due to underutilization to high inventory levels.

The chart on the right, below, shows that the company’s net income fell in each of the last four quarters. Red bars indicate that the free cash flow (FCF) lags net income, as it has for the last six quarters. Of even greater concern is the fact that FCF was negative for the past two quarters. Earnings that are not backed by FCF tend not to be sustainable in the coming quarters.

Source: Thomson ONE / StarMine

In the three months ended December 25, 2011, the company recorded a 5.5 percentage point decline in its gross margins, year over year, taking those margins down to 44.4%. In the 10-Q, management cautioned that underutilization of factory capacity will drive margins far lower in the near future – to a range of 31% to 32% which is 3 to 4 percentage points lower than the comparable 35.4% level used by management to calculate GM% for the December quarter. International Rectifier already is unprofitable at the higher gross margin level. With factories running at below-capacity levels, its asset turnover likely will fall even further from its current trailing four quarter level of 1.3 turns, which already is below the industry median of 1.9.

Semiconductor analysts predict that 2012 will be a year of strong demand for the industry. That may provide a silver lining to the cloud that currently appears firmly positioned above International Rectifier, as long as the company’s management is in a position to take advantage of that. Unfortunately, it seems as if managers will have their hands full attempting to steady the ship, and the StarMine EQ model indicates that the International Rectifier’s earnings may remain weak for some time to come.

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