With the increasing use of international supply chains and operating subsidiaries, the regulatory risk that affects a company’s operations becomes more difficult to ascertain. It is not always clear what aspects of the company’s operations are located in each country, and few investors would have the time or resources to investigate all of the potential changes in policy that could harm these international companies.
Consider the case of InfoSonics Corporation (IFON), a distributor of wireless handsets and accessories. The company both distributes handsets for other companies (notably, Samsung) and its own proprietary line of handsets under the verykool brand (which offer some pretty interesting features, like altimeters, barometers, thermometers and compasses, and they are rugged!).
IFON designs its handsets in Beijing and sells them through many different countries in Central and South America (and it is expanding its footprint through developing countries in southeast Asia). With operations in so many different countries, it is unlikely that many investors understood the regulatory risk that the company faced. Furthermore, given that the company’s market cap has hovered between $3 million and $20 million for the last four years, it is unlikely that any investors had a sizable position that would justify such complex and time-consuming research.
In most cases, regulatory risk isn’t going to be a game changer. The rule of law generally leads to fair outcomes, or at least clarity on what can be expected. In IFON’s case, dealing with developing nations in South America created a regulatory risk that has come to fruition, leading to a massive disruption in IFON’s performance. From the company’s recent 10-Q (emphasis added):
In 2009, more than 95% of our net sales of approximately $231 million were derived from distribution sales of Samsung product to carriers in Argentina. In late 2009, however, a stiff import tariff on certain electronic devices, including wireless handsets, was enacted in Argentina. The tariff had a significant negative impact on our sales beginning in the first quarter of 2010, and ultimately resulted in a decrease of 69% of our sales volume in 2010 compared to 2009. Then, in February 2011, Argentina enacted a further import regulation effective March 6, 2011, which essentially resulted in the final conclusion of our distribution business. Going forward, we expect our business to be centered on our verykool® product line. Our goal is to replace the lost gross profit from distribution revenues with higher margin verykool® sales through expansion of our product portfolio and entry into new geographic markets in Asia Pacific, Latin America and Europe.
The Argentinean government essentially killed, in a very short period of time, IFON’s distribution business. Investors who had purchased in 2008 believing that they were investing in a distribution business with a call option on the success of the verykool branded products suddenly found themselves wholly reliant on the success of an unproven brand, as the distribution business was decimated. The 2008 10-K says little about the potential for the Argentinean government’s actions, other than the standard (and oft-overlooked) boilerplate risk disclosure:
For the three months ended March 31, 2011, our net sales from continuing operations amounted to $9.5 million, a decrease of $18.0 million, or 66%, from $27.5 million in the same period last year. The principal reason for the decline was the negative impact of the import tariff in Argentina, where our distribution sales fell $18.8 million, or 78%, from $24.2 million in the first quarter of the prior year to $5.4 million in the first quarter of 2011. We expect that our Samsung distribution business in Argentina has now ended.
This isn’t even dedicated to regulatory risk, as this encompasses market risk (currencies) and potential hedging risk as well. Clearly no one was thinking this was a serious risk.
Approximately 88% of our revenues during the fiscal year ended December 31, 2007 were generated outside of the United States in countries that may have volatile currencies or other risks.
We engage in significant sales activities in territories and countries outside of the United States, particularly Latin American countries, including Argentina. The fact that we distribute a substantial amount of our products into a number of territories and countries other than the United States exposes us to, among other things, increased credit risks, customs duties, import quotas and other trade restrictions, potentially greater and more unpredictable inflationary and currency pressures, and shipping delays. Changes may occur in social, political, regulatory and economic conditions or in laws and policies governing foreign trade and investment in the territories and countries where we currently distribute products. United States laws and regulations relating to investment and trade in foreign countries could also change to our detriment. Any of these factors could have material adverse effects on our business and operations. Although we purchase and sell products and services in U.S. dollars and do not engage in exchange swaps, futures or options contracts or other hedging techniques, fluctuations in currency exchange rates could reduce demand for products sold in United States dollars. We cannot predict the effect that future exchange rate fluctuations will have on our operating results or financial position. We may in the future engage in currency hedging transactions, which could result in our incurring significant additional expenses and losses.
News of the tariff arose in December 2009, and investors not following closely would only have heard about it in January 2010 when the company issued a press release:
IFON may not have been certain about how a 30% increase would affect demand, but investors were pretty clear in their expectations. The company’s stock price shed 23% on this news.
In December, Argentina passed a new consumption law that effectively increases the price of certain consumer electronics, including mobile phones, by approximately 30%. The new law provides relief for products manufactured in a special industrial zone in Tierra del Fuego, Argentina. InfoSonics currently sells products manufactured outside of Argentina, and thus will be subject to the 30% increase. InfoSonics is uncertain as to how this cost increase will impact consumer demand, and our respective sales of Samsung products. We are uncertain as to how much of the production will flow through Tierra del Fuego due to logistical and production capacity constraints in that zone.
So what’s the point of all this? The key takeaway is that regulatory risk is real and that it would be a mistake to rely on management’s disclosures in assessing its potential severity. In the IFON case, even once the risk was no longer a risk, but had evolved into a certainty, management didn’t disclose it the way that it should have. They buried it in the third paragraph of a press release, and even then waffled on what the outcome would be. I don’t think it takes the benefit of hindsight to recognize that a 30% tariff would have a serious effect on the company’s sales.
Author Disclosure: No position
Talk to Frank about InfoSonics Corp