Hurco Companies 10-Q: Warranty Provision Concerns Revisited

Hurco Companies, Inc. released a 10-Q report today which covers the company’s fiscal second quarter ending on April 30, 2009. I covered the initial release of Hurco’s earnings for the quarter in an article last week. In that article, I mentioned some concerns about an unexplained drop in Hurco’s warranty provision in Q1 and the need to closely examine the warranty provisions once the 10-Q for the second quarter is released. Now that we have the 10-Q, let’s take a look at the warranty provision concern.

Calculation of Warranty Provisions

The company does not provide much in the way of details regarding how warranty provisions are estimated for any given period.  In the latest 10-Q, the following explanation is provided:

We provide warranties on our products with respect to defects in material and workmanship. The terms of these warranties are generally one year for machine labor and service parts. We recognize a reserve with respect to this obligation at the time of product sale, with subsequent warranty claims recorded against the reserve. The amount of the warranty reserve is determined based on historical trend experience and any known warranty issues that could cause future warranty costs to differ from historical experience. The warranty reserve may vary due to changes in sales volume, product mix and sales by region.

The final line in the explanation appears to be an addition compared to the language used in the 10-Q for the first quarter.  I contacted Hurco’s management and received a response stating that they would consider adding more detail. Unfortunately, the additional detail merely states the obvious and does not add much that is useful to the analyst, particularly in light of the apparent change in management’s methodology for recent quarters.

Warranty Provision History

Let’s examine the history of Hurco’s practices when it comes to warranty reserves and provisions over the past five years.  The exhibit below shows data for the last five full years as well as the first two quarters of the current fiscal year:

Hurco Warranty Provision (2004 to Q2 2009)

In my opinion, the appropriate metric to use when evaluating warranty provisions for a particular period is the ratio of the provision to cost of goods sold.  The alternative would be to take the ratio of the provision to sales.  However, since the company’s cost of sales is a more accurate reflection of what it would cost to provide warranty services and parts, I have selected that metric for this analysis.

For the five full fiscal years from 2004 to 2008, warranty provisions as a percentage of cost of sales ranged from 2.06% to 3.23%, with a drop between 2004 and 2005 followed by relative stability in the low 2% range over the past four years.  During the five year period, aggregate provisions totaled $11,488,000 and warranty charges totaled $10,013,000.  Based on historical precedent, it would appear that management reserved properly for warranty provisions during this time frame.

In the first fiscal quarter of 2009, warranty provisions as a percentage of cost of sales dropped to 0.29%.  For the latest quarter, the measure came in at 1.25%.  For the first half, warranty provisions as a percentage of cost of sales measured 0.71%.  This appears to be a precipitous drop from the reserves taken in prior periods.  Either a change in methodology has been adopted or management believes that the product mix or regional sales mix will materially impact warranty charges in the future.

If one takes the average warranty provision as a percentage of cost of sales for the last five full years (2.34%) and applies this number to cost of sales in Q1 and Q2 2009, we can infer that warranty provisions should have been far higher than recorded.  In aggregate, there would appear to be a shortfall of $573K for the first half of fiscal 2009.

What Does This “Prove”?

This analysis, taken in isolation, does not in any way “prove” that earnings are being managed or that the warranty provision is not correct.  Management could well have solid reasons for the change in approach between prior years and the first half of the current year.  However, we are not told of any such reasons for such a dramatic change which leaves the suspicion that earnings are being managed during a particularly rough period for Hurco from  a business perspective.

In the absence of convincing reasoning to the contrary, I will assume that warranty provisions should be adjusted to reflect prior historical averages and assume that earnings were actually smaller than reported in the financial statements (or more accurately, net loss for the first half should be higher than reported). My view is that a change in methodology of this magnitude requires additional disclosure if we are to accept the figures in the financial statements without making appropriate adjustments for historical experience.

Position Liquidated

We have liquidated our position in Hurco this morning at an average price of $14.75.  The decision was not made based on the warranty provision issue alone.  There are two additional primary factors that have changed the equation enough to warrant a sale of the position:

First, as I mentioned in the article last week, I have growing concerns about the fact that management has not trimmed inventory aggressively to reflect the precipitous drop in sales so far this year.  The probability that inventory will be written down has increased significantly.  If this occurs, the drop will be reflected in Hurco’s current assets and obviously would have an impact on metrics such as tangible book value per share.  The discount to Hurco’s reported tangible book value per share was one of the primary factors leading to the initial purchase decision.

Second, I am growing less comfortable with Hurco’s regional sales mix based on the condition of Europe’s overall economy.  Hurco is heavily exposed to Europe with over 63% of sales coming from that region in the first half of the current fiscal year.  Europe has generally been less aggressive in terms of monetary and fiscal stimulus compared to the United States and this will have an impact on economic growth going forward.  While I never make investment decisions based on macroeconomic factors alone, Hurco’s exposure to Europe is a contributing factor in the decision.

It is possible, and perhaps even likely, that Hurco will enjoy a rebound in business and share price over the next several years.  However, my initial purchase rationale for the position was based on the company’s apparent discount to net current assets and tangible book value.  With my suspicion that the company’s balance sheet is now more impaired that the reported numbers show, I can either exit the position or change my rationale for  holding the shares from a net current asset play to a call on the eventual growth in the global economy in general and Europe in particular.  In my experience, changing the investment rationale for a position is nearly always a bad idea in the long run.

Investment Performance

The position in Hurco advanced 11.07% from the purchase on April 7 while the S&P 500 advanced around 14% in the same period.  I normally do not consider investments in special situations (such as net current asset plays) unless I believe that there is at least a 50% upside, so the result is disappointing from that perspective.  In addition, underperforming the S&P 500 is always disappointing.  Nevertheless, all things considered, there are worse things than exiting a position with gains that probably should not have been acquired in the first place had a more thorough review of all factors been considered initially.  Should Hurco’s stock price return to the lows of March, it may well be worth looking at again even considering the potential concerns brought up here; however, at the current quotation, the margin of safety is not sufficient.

Hurco’s Response Regarding Fiscal Q1 Warranty Reserves

In my coverage last week regarding Hurco’s initial news release for fiscal second quarter results, I expressed some concern regarding the company’s provision for warranty reserves documented in the 10-Q report for the first quarter and indicated that I had not received a response to my inquiries on the subject.

Today, I received the following email from Hurco’s Chief Financial Officer explaining the company’s limitations in corresponding with investors based on Regulation FD.  I would like to thank Mr. Oblazney for his response and I am hopeful that further details will be revealed in the upcoming 10-Q report documenting Fiscal Q2 results.

Mr. Nagarajan,

SEC rules limit what I can share with investors on an individual basis. Under Regulation FD, I cannot selectively disclose material information to one investor unless it has been broadly disseminated to the public through an approved means, such as a press release or SEC filing. While it is not clear whether the answer to your question would be considered material, I trust you can appreciate it is difficult to make such a judgment in practice.

However, I have taken your question into consideration as we prepare our second quarter 10-Q. Thank you for your interest in Hurco.


John Oblazney

Hurco Posts Fiscal Q2 Results: Some Troubling Developments Emerge

Hurco Companies provided a press release this afternoon with results for the second fiscal quarter of 2009 which ended on April 30.  The 10Q report has yet to be posted to the SEC website.  While the results reflect significant weakness in Hurco’s business, this is hardly a major surprise given the continued turmoil in the global economy.  This was to be expected under the circumstances and a superficial look at the press release shows that Hurco only sustained a minor loss of four cents per share.  However, a closer look reveals some potentially larger problems.

Summary of Results

Hurco reported a net loss of $281,000, or $0.04 per share compared to net income of $5,467,000, or $0.85 per share for the corresponding period in 2008.  Sales and service fees for the second quarter came to $20,489,000, a jarring decrease of 65% compared to the second quarter of 2008.  While part of the decrease can be attributed to the stronger dollar, this was a relatively minor impact at around 5% of second quarter sales.

Sales were most impacted in Europe where a decline of 69% was posted.  North America experienced a 47% decline in sales while the small Asia Pacific business reported a 67% decline.  The picture does not look great going forward with new order bookings in the second quarter at $18,135,000, a decrease of 69% compared to the prior year period.

Gross margin declined to 26% compared to 35% in the prior year primarily due to lower sales volume and the decline in sales of higher priced VMX machines in Europe.  Competitive pricing pressures also had a negative impact.  Hurco cut selling, general, and administrative expenses by 36% from the corresponding prior year period.  However, cost cutting could not occur quickly enough to offset the dramatic decline in sales. SG&A expenses as a percentage of sales rose to 36.7% from 20% in the corresponding prior year period.

The balance sheet, at least at first glance, continues to reflect significant strength.  As of April 30, Book Value was $18.99 per share, tangible book value was $16.88 per share, Current Assets less All Liabilities was $14.72 per share, and the company had $4.34 per share in cash and short term investments.


As noted above, the fact that sales declined rapidly is not a major surprise.  However, digging deeper into the press release reveals some key concerns that must be examined in more detail:

Realized Gains on Derivatives

As Hurco reported in their latest 10K report, the company enters into foreign currency contracts periodically to hedge sales denominated in foreign currencies.  The purpose of the hedges is to mitigate against the impact of adverse exchange rate movements on cash flows.  As of January 31, 2009, the company had $2.8 million of unrealized gains, net of tax, related to future cash flow hedge instruments.  Deferred gains are normally recorded as an adjustment to cost of sales in the period when the sale that is subject to the related hedge contract is recognized.

In today’s news release, the company reported that $2,202,000, or $0.34 per share, of net realized gains on the hedge contracts were recognized on the income statement as other income.  Presumably, this gain was recognized in this manner because the size of the hedges the company entered into reflected a higher level of sales than now appears realistic.  Therefore, the hedges were closed out and recognized as income in the second quarter.

Obviously, investors must note that the net loss for the quarter would have been much larger had it not been for this one time gain on the derivative instrument.  Indeed, operating income reflects this weakness.  It would be wrong to conclude that Hurco can expect to repeat this quarter’s experience of a small loss going forward assuming current sales and expenditure levels.

Inventory Concerns

Inventories at the end of the second quarter rose to $64,880,000 from $63,294,000 at the end of the first quarter, despite the fact that sales for the second quarter declined 27.6% compared to sales in the first quarter.  Days Sales of Inventory (DSI) rose from 291 to 387 days.  This is historically very high for Hurco.  DSO averaged 162 days for the five fiscal years from 2004 to 2008.  The obvious question is whether Hurco is going to face any inventory obsolescence in the coming quarters.  The failure to significantly reduce inventory levels despite the large drop in sales over the past two quarters is a red flag indicating potential inventory write downs going forward.

Accounts Receivable

While Accounts Receivable fell to $15,903,000 from $18,587,000 at the start of the quarter, Days Sales Outstanding (DSO) rose from 60 to 71 days.  This could indicate trouble collecting from customers that are under stress from the impacts of the global recession.  In Hurco’s Q1 report, the company notes that many customers were impacted by tight credit during the quarter.  Given the nature of Hurco’s customer base, it is reasonable to suspect that uncollectible receivables may increase.  The question is whether Hurco has a sufficient reserve in the allowance for doubtful accounts based on current conditions.

Capitalized Software Development Costs

Over the first six months of the fiscal year, the company’s account for capitalized software development costs has increased by $386 million and now stands at $6,097,000.  While the capitalization of software development costs is in and of itself not an illegitimate practice, one must carefully examine this type of capitalized cost since if it was expensed during the current period, the net loss would have been that much wider.  Hurco’s capitalized software development costs have steadily risen from $2,920,000 at the end of fiscal 2004 to $6,097,000 at April 30.  Given Hurco’s reputation for having the best in class software for their products, I am not overly concerned about the legitimacy of the capitalized costs other than to note the potential manipulation that could potentially take place.  A healthy skepticism is not out of place in such situations.

Warranty Reserves

In the first quarter 10Q report, Hurco reported a $57,000 provision for warranties during the period which was sharply down from the prior year period’s provision of $669,000.  I inquired about the significant reduction given the impact a much larger provision would have had on Fiscal Q1 earnings.  I did not receive a response.  I am less bothered  by the company not wanting to comment on this than I am regarding the total lack of any response at all.  We must wait for the second quarter 10Q report to determine whether warranty provisions were back to more normal levels in Q2.  A continued pattern of small warranty reserve provisions could signal that management is attempting to smooth earnings.

Does the Investment Rationale Still Hold?

Does the investment rationale I wrote about in April still hold?  Obviously, I did not anticipate the continued weakness in Hurco’s operating results, although I had no illusions about a quick recovery to pre-recession levels.  I was more optimistic about management’s ability to cut operating costs to match the downturn in sales.  I was also more optimistic about management’s ability to bring inventories into line with lower sales volumes.  However, these are extraordinary times and Hurco still has significant strength from a balance sheet perspective.  While it is true that inventories and receivables may suffer from write downs if the current recession persists, I believe that downside is limited by the strong balance sheet position.  Management is also in place that has experienced the prior economic downturn earlier this decade and the overall track record outlined in the prior article still holds.

One of the main lessons I have learned from studying Benjamin Graham’s writing over the years is to view the balance sheet as the anchor of value for a business.  An overemphasis on current income during any quarterly or annual period is very common, and investors who do not insist on a solid balance sheet can suffer badly in downturns.  In this particular case, Hurco’s balance sheet provides a great deal of downside protection, although it obviously does not eliminate risk.  Management could certainly make decisions that will erode the balance sheet in the coming quarters, although their overall track record provides some reason for optimism.

In my opinion, Hurco should still perform very well over the next three to five years provided that the worldwide recession does not degenerate into a depression and the company’s technological superiority is not eroded by competitors during this timeframe.  I am holding my shares at this point, although my enthusiasm for continuing to hold if price recovers to tangible book value has been significantly reduced.

For interested readers, The Inoculated Investor has posted equity research on Hurco that I found very well written and worth careful review.

Disclosure:  The author owns shares of Hurco Companies, Inc.