Price: $2.26 (10/3/11)
After reading the bull case over at Whopper Investments blog the story seemed too good to be true, a company selling for less than NCAV and with excellent ROA/ROE. Whopper doesn't discuss why the company is trading at a discount so I thought I'd take a stab at it myself.
The reason I'm doing this is because I believe most or all value investments have a problem, a big visible problem. Value investing is determining that the visible problem doesn't matter as much as the market thinks it does, and can look beyond it.
Whopper has a great overview on the company and some financial details. I will highlight a few points which are key to understanding the rest of this article.
-AEY trades at $2.26 against a NCAV of $2.57/sh
-The company buys and resells used router equipment and used cable tv equipment.
-They carry a large inventory of older or obsolete inventory as a value proposition to clients looking to replaced a failed device without needing to upgrade.
-The routers are sold without software, or the brain center of the router.
-AEY recently entered into a new reseller agreement with Cisco redefining the terms of their agreement.
So why is this company cheap?
Is is misunderstood? - This category has been my bread and butter of net-net situations, a company will have poor earnings but have a large slug of cash or marketable securities that the market is missing. The market will focus on the earnings story missing the fact that the company is trading at a discount to liquid assets. This isn't the case with AEY, they have a nice amount of cash and inventory but there are no hidden assets here.
Cable TV subscriptions declining - Call this the Hulu/Netflix effect, households are canceling cable and signing up for streaming services. I know this is true in our house, we don't have cable, just Netflix. I don't know how strong of an effect this will be in the long term, but it seems to be popular currently.
The real reasons
Sales have fallen off a cliff - As of the most recent quarter revenue was down 35% YoY and new equipment sales were down 41%. In addition refurbished sales fell 23% in the most recent quarter.
It's difficult to understand or know exactly why revenue is down, management blames the drop on the weather, frozen capex at clients and the new partnership agreement. I'm dubious of a management that blames poor router sales on the weather. I don't know of any companies that postpone sales due to severe weather, it's actually the opposite. If clients were in severe weather areas I would expect to see an increase in sales replacing damaged equipment.
The sales numbers are terrible in light of the fact that Cisco's sales have been increasing over the same period of time. The conclusion I draw is that Cisco has the cream of the crop customers while AEY has some of the bottom rung customers who's wallets are still tight. This leads into our next point..
Limited ability to sell to certain customers - As part of the new partner contract the company agreed with Cisco to not sell to certain customers. The documents don't outline exactly who those customers are but from my experience the limitations are usually on bigger accounts. So Cisco would service the Time Warners and Comscasts while Addvantage services smaller regional cable companies.
In addition to the limitation on certain customers Addvantage is also limited in their geographic range, the new agreement limits their ability to sell internationally. I'm not sure how big of an impact this is but management called it out specifically in the notes mentioning that they had previously sold outside of the US and this would no longer be possible.
Change of business strategy resulting in higher costs - As part of the new partnership agreement Addvantage will no longer have to carry as big of an inventory which is a good thing, the side effect is equipment costs will be higher going forward. The higher equipment cost will cut into margins and is a permanent change not something temporary that will reverse. Like many of the other things the impact of this isn't broken out exactly.
Why buy Addvantage when you can buy Cisco?
As I looked into Addvantage it became very clear to me that the company lives and dies by Cisco, if something were to happen to Cisco I'm not sure they would be able to survive. Secondly Addvantage is selling Cisco routers without any routing software which is the brain center of the device. A router is nothing more than a collection of ethernet cards, the software determines efficient routing of data and the feature set available to a user. Anyone can build a cheap router with an old Linux computer and some discount NIC cards, but the reason people pay Cisco so much money is for their IOS software that runs the router. Customers purchasing from Addvantage still need to purchase IOS and license the software from Cisco before they have a working item.
In thinking about this I decided to put together a few stats of Addvantage side by side with Cisco:
Addvantage is clearly cheaper than Cisco, and this begs the question for me, would I rather own Cisco at a 25% discount or Addvantage at a 50% discount. I'm not sure, and don't own either, but I'd love to hear thoughts either way.
Disclosure: No positions
I wouldn't go as far to say they live and die by Cisco. Cisco as a vendor makes up about 25% of the inventory. The price discounts far below losing Cisco entirely. The company actually advertises itself to customers as sort of an "oh shoot" moment supplier and people buy into it. They wouldn't so stupid as to buy from Addvantage at a higher price if there weren't situations like that. So if there is better weather and less "oh shoot" moments, then the sales will go down. That is why they have a decent profit margin. The market isn't totally rational, but businesses generally are in this kind of thing -- they wouldn't pay a higher price just to be a sweetheart.
ReplyDeleteThe inventory too is discounted far more than it has been historically by the obsolescence reserve (which is stated at estimated realizable value). So the price could be double counting this inventory discount if it goes by the numbers.
I was curious where you found the management blaming severe weather for declines in revenue. On the 10-k, it says this regarding weather:
ReplyDelete"Many of the products that we sell are installed outdoors and can be damaged by storms and power surges. Consequently, we experience increased demand on certain product offerings during the months between late spring and early fall when severe weather tends to be more prominent than at other times during the year."
The Cisco agreement only impacts new hardware, not used. There is uncertainty over the impact, even management admits they can't tell because the whole industry is struggling.
ReplyDeleteThe ultimate reason that AEY is cheap now is that cable companies aren't doing any capex. Subscriber growth is hurting from the lack of new housing starts (new homes/subdivisions=additional cable,parts,etc) and the "cutting the cord" issue you referred to. But eventually cable companies will need to upgrade their services and systems to add more HD channels, bandwidth, etc if they want to compete with the telecom providers who are taking away business. AEY should benefit when the cable companies start spending, and their balance sheet is strong enough to see them through until then.
Sorry for the delay in responding, I was on a vacation at the beach and didn't take a computer with us.
ReplyDeleteI've been thinking about these comments and I can't quite reconcile them here's why:
On one hand AEY makes money due to equipment failure, there should be no seasonality related to this. This is the line management trumpets how they need to have a lot of inventory on hand. Routers fail all the time due to age, and if they fail in bad weather it's unlikely a cable company will decide to wait until the weather clears to fix. In addition I would think bad weather would induce failure which would result in an uptick in business.
Yet at the same time capex is usually blamed as a reason for being cheap. But if the company's advantage is it has a large inventory reserved for failure capex shouldn't play a role.
So the position is that either the company needs to have the inventory on hand so it can supply parts which would mean that the capex explanation doesn't make sense. Or capex is the reason for cheapness which makes me question why they have such a large inventory and management talks about having parts for an emergency failure moment.
One other thing that really makes me question that whoops it broke line, I requested a quote on a few pieces of hardware through their site. A week later and I haven't received any communication, if this was a critical equipment failure I would be dealing with another vendor.
I also think capex seems to explain some of the cycles in equipment purchases as well.
Thanks for the comments, I still haven't really resolved to myself why this is cheap, and what will make them uptick. For some reason I just don't have a good gut feeling about AEY. This doesn't make it a bad investment, it's just that I won't be investing.
Nate,
ReplyDeleteThe company's 10-k says that bad weather helps in increase demand:
"...we experience increased demand on certain product offerings during the months between late spring and early fall when severe weather tends to be more prominent than at other times during the year."
Thanks for the comment, that's what I would suspect if they are a supplier of last resort type of a thing.
ReplyDeleteIn response to where I found the weather comment asked by an earlier commenter I looked. In the most recent 10-k on page 12:
"Equipment sales were negatively impacted by several factors including the continued economic downturn in the cable television industry as the MSO customers continue to conserve cash and limit capital expenditures and the negative impact of the Cisco agreement, both as discussed above, as well as severe weather conditions in the second fiscal quarter of 2011. "
So on one hand management has said that severe weather helps sales, yet on the other hand they have blamed severe weather on bad sales.
Thanks Nate, I didn't notice that note about the weather. Its in the latest 10-Q. You have a good point, it looks like the company play weather both ways which is strange. I just emailed Investor Relations to ask them about it.
ReplyDeleteLet me know if you get a response from the company, I'd be interested to hear it.
ReplyDeleteHello,
ReplyDeleteI had a look at their latest annual report and would like you opinion on the below:
Do you know to which extent can the new Cisco Agreement be a drag on earnings?
Also, do you think that AEY, as Motorola re-sellers will be affected by Google's Bid for Motorola Mobility, or it has nothing to do with the parts AEY markets?
tks
Filipe
Filipe,
ReplyDeleteThanks for the comment, sorry it's taken me a bit to respond to it.
I don't know of the exact drag on earnings, but I believe that AEY won't be able to sell some of the higher margin items. Also they're restricted in who they can sell to, they are limited to smaller second-hand clients. For management to mention this I believe it'll be a material impact to earnings, I just don't have any idea of a magnitude.
I don't think AEY will be affected by the Google acquisition at all. I believe Motorola Mobility only manufacturers cell phones whereas the other portion of Motorola (not purchased by Google) is who makes the equipment that AEY sells.
Nate