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.

Concerns

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.