Tuesday, June 30, 2009

Severity of Recession Trips Up Flow International

Chief executive Charley Brown of Flow International (FLOW-$2.39), a manufacturer of water-jet and routing machine tool systems for a variety of industrial applications, optimistically opined in a press release issued last week that although “the global economic slowdown continues to impact business, roughly two-thirds of its revenue stream has stabilized,” and the company is positioning itself for sustainable, long-term growth. Permit the 10Q Detective to proffer some skepticism, as red flags uncovered in Flow’s annual report for the year-ended April 30—combined with prior faulty predictions by Brown—suggest a successful turnaround is far from a certainty.

Fresh on the heels of a
multi-million Airbus contract, Brown braved the recessionary headwinds blowing last summer and optimistically told analysts on the 2008 earnings call that Flow would deliver 20 percent compounded EBID growth on a 10 percent annual increase in annual sales for fiscal 2009. To the contrary, the company posted a loss of $23.8 million, down from a profit of $22.4 million a year earlier, primarily driven by a $29 million charge to settle patent litigation and an aborted merger with smaller rival Omax and $6.9 million in restructuring charges recorded to reduce global staffing levels.

“It always looks darkest just before it gets totally black.” ~ Charlie Brown, Peanuts comic strip

Sales fell 14 percent to $210.1 million, resulting from a significant decline in system orders as customers delayed capital spending and expansion plans. In addition, although backlog increased 30 percent to $45.7 million, customers in North America and Europe negotiated for longer lead-times (from quote to purchase).

In our opinion, Brown erred in his 2009 guidance by mistakenly believing that Flow’s diversified revenue profile—spread across geographies and end-users—would shield the company from isolated industry-specific slowdowns. Although no single customer makes up more than five-percent of total sales and roughly 58 percent of revenue comes from customers outside the U.S., management under-estimated the breadth and scale of the global economic slowdown. In addition, the usually strong recurring revenue stream from spare parts dried up in 2009, falling five-percent year-on-year due to lower capacity utilization in customers’ operations.

At April 30, Flow held $10.1 million in cash, of which approximately $6.1 million was held by non-U.S. subsidiaries; working capital of $27.9 million plummeted to a skeletal $2.1 million (after backing out the $8.7 million in deferred tax assets and $17.1 million in deferred acquisitions costs payable to Omax); and, cash used in operations was $6.5 million. Should operations continue to deteriorate in coming quarters, this anemic balance sheet could weigh-down Flow’s growth/expansion plans, forcing the company to raise additional capital through financing vehicles potentially dilutive to existing Flow shareholders, such as a recently proposed $35 million
stock offering.

Irrespective of its operating performance, the company is responsible for covering more than $38 million in contractual obligations and commercial commitments coming due in 2010 – 2011, including operating leases - $5.5 million; current portion, long term debt, notes payable and capital leases - $5.0 million; and, purchase commitments - $23.3 million.

Just as worrisome, weak operating results in coming quarters would likely trip
loan covenants under existing credit facilities, too, further limiting the company’s ability to obtain financing on reasonable terms.

“In the book of life, the answers aren't in the back.” ~ Charlie Brown

Decreasing liquidity, questionable credit worthiness, and confutative ramblings of a chief executive—Flow International’s ability to deliver 20 percent compounded EBID growth rests entirely on a global economic recovery. If all else fails, management could always think positively, and manage its future earnings by decreasing the $20 million valuation allowance on its deferred tax assets—like it did in 2008!

Editor David J Phillips does not hold a financial interest in any stocks mentioned in this article. The 10Q Detective has a Full Disclosure Policy.

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