ADDvantage Technologies Group: Bad Quarter, Good Price

ADDvantage Technologies Group (AEY), a distributor of cable equipment (think set top boxes, encoders, etc) to large and small cable companies, reported a nasty looking Q2 earnings report last week .

Sales were down 16%, margins decreased, and every product category showed a decline compared to last year.

I was a buyer.  Why?

In this market, it is difficult to find a company with strong cash flow, margins, and return on capital at a cheap price.  After the shares declined 14% on the earnings news, AEY is cheap by almost any measure.

With a PE of 7 and an EV/EBITDA of 4, AEY currently sells below book value and around its net current asset value. These multiples are typically seen on companies that are in danger of bankruptcy, not a company that has delivered positive free cash flow in each of the last ten years- even in the meltdown of 2008 and 2009.

AEY does face some challenges.  Their customers, cable companies, are delaying capital expenditures and growth of cable subscribers is down- largely due to  lower housing starts and the general economic malaise.

However, the company’s business model is scalable.  Looking at the recent 10-Q, sales were down 16% but so were the cost of sales, keeping gross margins steady at 30% and in-line with their historical average. Earnings and free cash flow were still positive and the balance sheet remains strong with a small amount of net debt.

AEY also possesses a medium sized competitive moat- rare for a distributor.  The company holds on to large amounts of new and refurbished cable equipment to meet customers’ demands even on short notice.  This has earned the company a reputation as a “On Hand, On Demand” supplier and allows AEY to earn those 30% gross margins.  This large supply of inventory gives AEY a great opportunity when cable companies start spending again which due to increased competition from telecoms, will need to happen.

While the on hand inventory gives the company a competitive advantage, it does provide the greatest risk to the AEY investment.  In the latest quarter, the company held $27M worth of inventory, tying up a significant amount of capital (the market cap of the company is around $30M).  It is vital that management continues to control this risk as effectively as in the past.  Insiders own 50% of the company and have been in the business for 25 years, so I feel comfortable with this risk for now. The inventory also helps provide protection on the downside, as the company’s net current asset value is $2.43 per share.

The other major risk is the new contract AEY entered into with one of their major suppliers, Cisco (CSCO). Under the new agreement, AEY will no longer hold Cisco’s new products in inventory, serving as a reseller instead.  While this will lower margins on selling Cisco’s products, it should increase cash flow as inventory costs decrease.  The deal also limits selling into the faster growing Central American market. The long-term impact of this contract will need to be monitored.

Using conservative scenarios, I value AEY in the $4-$6 range, nearly a double from the recent price. The $2.43 NCAV provides downside protection. Saj Karsan and Whopper Investments have recently written about AEY here and here.

Disclosure: Long AEY

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6 Responses to ADDvantage Technologies Group: Bad Quarter, Good Price

  1. Pingback: One more nice article on AEY – Whopper Investments | Whopper Investments

  2. Pingback: Get Aggressive With Your Play Money | Thousandaire

  3. Juan Velasco says:

    From their quarter results:

    Net refurbished sales decreased $2.4 million, or 47%, to $2.7 million for the six months ended March 31, 2011 from $5.1 million for the same period last year. The decrease in refurbished equipment sales was primarily due to a decrease in sales of digital converter boxes of $1.5 million and the factors discussed above. The decrease in sales of digital converter boxes is primarily due to lower demand in the market and market price erosion.

    But on the other hand:

    Cost of sales as a percent of revenue was 69% for both the six months ended March 31, 2011 and 2010.

    Now I can not understand if they say that refurbished sales dropped almost by half which due to price erosion of their set top boxes then how is it possible that their margins are unaffected? If their set top boxed have now a much lower sales price but their inventory cost is the same then the margin should be smaller but the margin is exactly the same that does not make sense to me. Can someone explain?

  4. mosinvestor says:

    New equipment was a much higher percent of sales during the 6 months than refurbs and would include items other than set-top boxes, which may not have had as big of a price impact. Also, some of the newer set-top boxes would have been sold under the new Cisco agreement, lowering the cost of sales. There was also a decrease in their reserves for obsolete inventory which inched margins up a bit. The change in reserves is something to keep an eye on.

  5. Juan Velasco says:

    Thank you for you response Mol,

    Refurbishments dropping by around half and no margin impact deserves a very clear explanation from management for my taste before investing anything. Specially when for 2 quarters in a row the margins are left intact while sales are dropping and inventory is huge, I just have never seen that in my previous experience.

    Your interpretations are possible but I would prefer to hear that explanation from managent, as I see it if they talk about price erosion of set top boxes they should be very clear if that affects new sales or inventory sales and be very clear about what keeps the margins intact.

    Kind regards,

  6. Pingback: Analys av Addvantage Technologies Group | Värdebyrån

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