This is Part III of III from my recent conversation with Syntax-Brillian Chairman and CEO Vince Sollitto. See the main interview page.

James Cullen: One thing you mentioned as part of the first question is that the number one issue is working capital. And you have all this demand – I think you said three times the demand you can meet now with the financing you have – and as part of that secondary offering you raised about the equivalent of all that money went to inventory and tooling deposits…

Vince Sollitto: Ok, let’s separate those two things out. The first one, actually, it went to pre-payments for – well, when you count the ARs we collect and that money, it went to basically three things: it went to paying down ARs early to Kolin to get cash to Kolin to help them purchase, it went to tooling deposits for the plastic molds for new models. Everytime you do a new model, a new look, you have to get these molds – they’re very big, very expensive, and we – two ways you can do this, you can pay for the molds and own them, meaning you use your cash for that, or fortunately for us because of our supply chain partners both [the plastics company] and Kolin, what we do is give them a deposit – really not a cash deposit, it’s a purchase order for the mold. They then take that to their bank in Taiwan at 3% and can borrow the money to pay for the mold. So we carry this kind of tooling deposit thing on our books, and the reason we carry it on the books is, we pay for the mold in every part that we buy. In other words, we’re chipping away at that deposit as we make units, but we have to keep it on our books because in the event that we didn’t use – didn’t actually get 60,000 units of a particular model, which would amortize that total amount, we would have to write that off. So the auditors have to check that every quarter. They go through the deposits, you see one number, but really it’s a huge spreadsheet that 323s, 523s, 542s, all that stuff. They’re each there and there is a mount for the mold and there’s the number of units against that. So that’s all being checked and what’ll happen is, you’ll pay off a mold and you’ll design a new plastic, or you might have two factories – you need two molds – because you’re making them in the US and in China. Or you might have gone well beyond the lifetime of the mold and you need to get another one because that model is selling so well that you’ll need to replace that mold because it wears out.

Now, back to the money. Let’s start at the beginning. The company started because the only thing that we have in terms of credit financing is receivables financing – meaning that for CIT and Preferred Bank, they have basically given us a line of let’s say $100 million, and what they say is, for eligible receivables – in this case that would be reputable US companies – let’s say we have $100 million of receivables, they’ll let us borrow $80 million or 80% of those receivables. So we get that – the receivable money – that we were going to collect in 60 days in the US, and we send it right to pay for the next TVs that are going to ship in the next quarter, which we’ll be paid for in 60 days. So kind of the way you look at this is to say, you don’t really grow that fast in that scenario, because they’ll only give you 80%, you’re paying 80% because you only have a 20% gross margin, and so you’re really only able to gain a couple months worth of growth with that method. Now, how do we do 250%? We’re fortunate that we did some offerings – some equity offerings to our supply chain partners, we did a PIPE in December 2005, we did the follow-on offering – but we also were fortunate in that we were able to take our purchase orders which we gave to Kolin, who then distributed those orders to our supply chain partners, and they were able to borrow in China and Taiwan against those orders. So we got the equivalent, over time – at this year it kind of peaked at $430 million worth of working capital lines that were issued to our partners – so between that, our own AR financing, and the equity offerings we did, that was our working capital and we were able to stretch that into growing at about 250%. Now what happened recently is that as a result of a company – one of these Taiwanese LCD companies that was selling to the clubs – they had a huge return problem and as a result they had borrowed on the purchase orders. In other words, they had borrowed on the orders, not on the receivables, so what happened was that the amount they got paid because there were returns was so much less than they borrowed that they went bankrupt. When that happened the bank was left holding the bag; the banks in Taiwan instantly put a lid on loaning money trying to understand whether this was a problem in the US, because our economy had gone through some difficulties as you recall, and as a result they said if you have a $100 million line, but you’ve only borrowed $60 million so far, we’re capping you at $60 million for now.

JC: They put a freeze on it.

VS: Right, they didn’t say you had to pay back what you owed, but you can’t borrow anymore. That had the impact of taking about $200 million out of – instantaneously taking $200 million out of our working capital – and of course right at the worst possible time, right while we were getting ready for the September and December quarters. Now, we were able to recover some of that, one of our suppliers is WesTech out of Singapore, they were able to borrow – recover their borrowing more quickly – Kolin did do a convertible debt, they’re in the process of doing a convertible bond as well, but we haven’t seen the results of that yet and we may not until the first half of October, but we will get that back because I think things have loosened up, we have a better interest rate and the Beijing Olympics will drive the economies in Asia, and I think that the banks over there are recognizing that this is a problem that many of these Taiwanese LCD companies who borrow against purchase orders like the Vizios and Emersons and Westinghouses and Polaroids, run the risk of – they’ve already taken the money, and if they don’t get paid – they’re bankrupt. Whereas we don’t do that, we borrow against receivables, not purchase orders. So I think they recognize that, but its certainly put a crimp on the supply chain for LCD TVs into the US market and what we’re seeing is that many of the retailers – many that we don’t do business with – have contacted us saying, ‘I need 200,000 or 100,000 of these units, can you get them for me? I can’t get them from any place else.’ And this is not the Tier Ones, the Tier Ones have deep pockets, so their able to do it, but of course their price point only covers one aspect of the market – you need to have the guys that are priced 20% lower like us and the Vizios and the others. So we’ve gotten a lot of requests for that, and it became very clear that there is a little more pervasive problem in Taiwan than just this one company, Protron, going under. Now, what does that all mean to us? What it means to us it that we clearly did not have as much working capital temporarily as we wanted. We’re trying – and it’s a very difficult problem because it’s such a moving target – trying to make sure that we can figure out how much we can deliver and when to go back to our retailers and say look, you wanted 500,000 units, I told you you could get 300,000, now as a result of that you’re only going to be able to get 220,000. That’s the difficult thing for us, to make sure that we communicate correctly with these guys because they do national ads and set these things up well in advance. They can’t have a situation where they’re advertising that they’re carrying an Olevia 32” TV and then not have enough product to stock all the stores nationwide. That’s a big problem for them, truth in advertising and that sort of thing… so that’s what we’ve struggled through recently. What have we worked on in the meantime? We have been approached as a result of the [10-]K being filed and for those people who are in the industry, they’ve looked at the K and said, ‘this is a really good company, they have some growing pains and some process problems but basically Ernst & Young gave them a clean bill of health, and if you look at the numbers and the financials and the fundamentals, if we give them $100 million in debt, they should be able to in 12 months be able to turn that into $400 million in revenue and $40 million in operating profit.’ Because we’re putting all this money to work in the business, it’s not like when I was at Photon… and we’d do a $150 million follow-on offering and put $120 million on the balance sheet so I could sleep at night, that’s not the case here, every dollar that we don’t need to pay bills, salaries, that stuff, we’re going to put to work to increase our sales. So they look at that and say, ‘if you can get a $40 million return on a $100 million investment, you can afford to pay me – a good interest rate.’ We’ve had a lot of people contact us about that. Now, a good interest rate for them is probably not something we want to be locked into for a long time, and so the negotiations we’re going through now are, how can we take advantage of this but not get ourselves locked in for three to five years on an interest rate we know is inflated at the moment. So we’re working on that. Finally, the whole issue of China is one that I feel really good about what we’re doing there – I don’t know if everyone understands it. What I’ve said is, we have the problem with the concentration of receivables at our distributor South China House of Technology. They’ve done a great job for us, absolutely; we would never have gone from 2% to 5% market share in the last year and been the #1 non-Chinese brand in China in the December quarter last year without them. Because they hire the kids to run the kiosks, they man them, and they hawk the product like a Chinese product, and they do a lot of local advertising and promoting of the Olevia brand. But, there is no question that when people said, ‘look at this, a huge percentage of AR are from a single customer that’s a private company that we don’t have publicly released financials on, and that could be a problem, maybe they won’t get paid.’ Now the crazies say they aren’t even real sales, they’re phony, but that’s – I don’t think people pay attention to that made up stuff – Ernst & Young obviously spent on this audit… they estimated about 100 man hours of people in Hong Kong and Taiwan and China who worked for Ernst & Young going over that relationship and gave it a clean bill of health. But, it is a concentration of AR and we were unsuccessful in finding a bank that would provide us with either factoring or AR financing because we were once-removed from the actual retailers, so we made a decision to change from a distributor relationship – a stocking distributor, they took ownership of the product – to a rep company structure whereby they still do everything they did before, they still hire the people, deliver the product, provide the logistics and all that, but now we pay them a commission as opposed to revenue and the revenue and the AR now comes to us from a dozen retailers in China and Hong Kong who are guys like Best Buy and Circuit City and Target – the Gomes, the Five Stars and Broadways and Fortresses – who are internationally known as retailers that are very reputable. We have been told, and I don’t have term sheets… yet, that say we should be able to borrow against those receivables because the paper is coming to us from those kinds of retailers. Once that is in place and we can borrow against those receivables, then the opportunity for us to get back on to this very high-growth trend in China is possible. We were growing at a phenomenal rate, about 300% in China, because the market is growing almost twice as fast as the US, and also because of the unique difference of the 120 days and lower interest and 60 days and higher interest we get higher gross margins in China than we do here. It’s just a different world. The retailers here say, ‘if you give me another 1% discount I’ll pay you in 30 days;’ the guys in China would never ask that – ‘I’ll pay you in 120 days, that’s the deal.’ The gross margin is better but the time is longer so when you look at it from the standpoint of where we are right now given everything going on, did we think it was a prudent thing to let China – which by the way, does not have the same working capital issues because it’s a completely different supply chain for China – do we feel comfortable letting that AR balance grow faster than North America and become a higher percentage of our total business? And the answer is that we didn’t, we didn’t feel comfortable. Not that we’ve ever had an uncollectible AR over there, we haven’t, but did we feel having that large an AR out there for 120 days? No. It’s our money, it’s the shareholders’ equity, and it didn’t make sense for us to do that, so we decided to limit the sales in China in September and December. If we were able to put in place the financing issue, we might change that. But right now, that is the posture that we’ve taken. Hence you saw the numbers in September come down, while we never really gave an estimate for September by itself, we did give an estimate for the second half of the year combined and it’s clearly a reduction in our mind from a number that was probably around $250 million down to about $170-180 million and that’s the real driver behind it.

JC: LCoS (Liquid Crystal on Silicon) is a very promising area and I’ve heard you talk about it before in terms of that’s really the big, monster TVs and you’re hoping to introduce that in greater numbers. That, and Vivitar – the Olevia LCDs are obviously the focus here, but what do you see those two segments contributing to the company in the future?

VS: Let’s start with Vivitar. Vivitar is a great brand – it’s known maybe not by your generation but by my generation as – when we all had Canon/Nikon cameras we all had Vivitar lenses and Vivitar flashes. So Vivitar is a great brand name that was owned by a Taiwanese holding company that had used it as a vehicle to sell surplus digital camera parts into the industry. So it really got run down, the website was broken – didn’t work – and no marketing had been done in two years, so things got really run down and they needed to sell the company for other reasons. They were also interested in our stock, wanted to get some of our stock, and so we were able to get a good buy on it. What were we looking at there? My feeling was that we had just done a study of entering the European market, which is the largest LCD market today – not because they have HD, they’re behind the world in HD, but the European consumers like flat panels – and we had looked at bringing the Olevia product country by country, the brands and the channels are tied together in Europe, and bringing it country by country was going to take us 18 months to accomplish that and make money. And I said, that’s brutal. When we looked at Vivitar we found that 80% of the retailers that sold Vivitar cameras also sold televisions, and we enquired if they would be interested in carrying a Vivitar branded LCD TV. And they said yes, very much so. We then looked at the… camera business and discovered that, in Europe, the camera business was actually quite healthy – Vivitar is the #3 or #4 selling brand in the UK. So we looked at it and said, this is amazing, but couldn’t we get some better cameras? The cameras were surplus-type stuff. So we talked to Hope Frank and she’s a genius and we’re blessed to have her on the team, and she said, ‘I think we could do this especially when you look at what we’re doing at Target and some of the other retailers, they would really like to buy more stuff from us.’ Once they go through all the trouble of qualifying a company and setting up the ERP systems, getting involved with the marketing groups, that sort of thing, just selling one product is not as effective as having a suite of products. We looked at it and sure enough, Hope launched that yellow underwater camera, stuck it in the Oscar grab-bags, the trashy news magazines… the paparazzi caught Brooke Shields with the camera and it became the must-have gadget for the summer and sold like crazy on Target.com at $199. Meanwhile she introduced the gold camera, and one of the things she did was with the AV sponsorship that we’re doing, while in the US we’re using Olevia as the founding sponsor, at the O2 in the London Financial District she used Vivitar. And so the Vivitar brand is getting enormous exposure in Europe, through the O2 and it’s a very classy exposure. So what’s happened is the gross margins over there are very good for selling the new products – now it doesn’t hurt that we’re buying the stuff in dollars and selling it in pounds and that’s another thing to remember – but they’re doing very well. Finally, when we decided to enter the TV market, given the lack of resources we hoped to be selling 50,000 TVs in Europe this year, and given what’s happened we looked at that and decided we’re going to enter the TV market in Europe at the high end. So we took the extra time to design some new plastics that are very thin, piano black, speakers are hidden behind, they have a very small 1” trumpet underneath the TV to bring the sound out; we showed them at IFA which is a big show in Berlin – that is the largest electronics show in the world – and they were very well received and we’ll start shipping those in the first half of calendar ’08. So Vivitar we think has a good chance of bringing the gross margins back up into the range we’re interested in, 20ish range, and we believe that the brand will eventually help us get back to the US with a reputation that will be not sold in Wal-Mart, but will be sold in Target and Sears and those places.

Now LCoS is a different story. LCoS is a great technology, undisputed the best picture quality in the world, better than LCD, plasma, DLP, you name it – it is clearly the best choice in terms of price performance in the large sizes, 60-70 inches. The problem of course is that it’s a new technology. Basically only three companies that have it; Sony – their SXRD is LCoS, JVC is D-ILA and that’s LCoS, we have a trademark on LCoS, that’s why they use a different name, unfortunately we’ve seen JVC go out of the business because they’ve been purchased by… I think Harman Kardon. They were purchased by a holding company and they exited the LCoS business. So now it’s just Sony and us; that doesn’t bode well because the retailers do not view us as viable – which they shouldn’t, we haven’t shipped in any kind of quantity yet – so they say, ‘this is a problem if Sony is the only one with LCoS, they could own the rear projection market and they already are #1 or #2 in LCDs,’ and that would be a problem for the retailers…
So that is an artificial constraint on demand. We believe that a 65” laser light engine, 7” thick LCoS TV at somewhere around $1500-2500 would be a phenomenal seller in competing against even flat panels. To get there though is going to take cost reduction, cost reduction really comes with one simple thing and that is volume. It’s a chicken and egg problem, we’re not like Sony – we don’t have the resources to forward price a product, drive the volume have the volume drive the cost and make money on the backend. So we need to find a way to get that cost down. We found that in the Chinese government, who has a real interest in LCoS, we’ve done the joint venture on the light engine factory, but it has not taken off as we’d like. There are meetings going on in China, in Beijing, as we speak, to talk about the future there. We’ve basically told them that, we either have a significant volume LCoS business together, or we don’t believe that Syntax-Brillian can continue to carry the losses there. And so hopefully that’s going to put a fire under the guys in China to get moving here, they have been very encouraging, of course the President of China went and toured our factory, declared it a national technology, and all that is good but we also want to see some tangible investment that will drive the kind of volumes we need. LCoS is a wait-and-see. It is a fabulous technology, anybody who has ever seen a TV says that, if LCoS goes away I think everybody who is in the know will buy at least two of them and stick them in their closet to make sure they have them for the future. Hopefully, between Sony and Syntax-Brillian, we can make LCoS a very significant part of the home theater experience for a lot of people.

JC: Vince, thank you very much for talking with me, and I really look forward to seeing you guys put up some big numbers in the future.
VS: Alright, thank you.

Part I: Vince’s thoughts from the perspective of BRLC shorts, why the earnings report was delayed, and Jim Cramer.
Part II: Vince discuss the CFO situation, the Kolin relationship, and gross margins.

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