Don’t cut out the middleman: Tech Data

July 12, 2010

Tech Data (TECD) is a distributor of electronics in the US and European  areas. Its role is to sell a mix of primarily IT products from original  manufacturers and entities identified as “value-added resellers” and to  perform various related ancillary services, and it is one of the largest such distributors in the world. Approximately 30% of their sales come from HP.

It is unusual, perhaps, to find a value opportunity in the largest of anything, as value stocks tend to be overlooked, but the company’s market cap is a “mere” $1.94 billion, still below the radar of the largest institutions. More interesting for our purposes, nearly all of that value is represented by tangible assets: $900 million in cash, $2.5 billion in receivables, $1.8 billion in inventory, against $3.5 billion in liabilities, total $1.7 billion in tangible assets. This leaves a gap of about $240 million, which is just over a year’s free cash flow. The value of these tangible assets is safeguarded by agreements with some clients to return unsellable goods or to receive compensation in the event of the seller offering discounts or rebates. It seems therefore safe to conclude that much of the money invested into the firm will still be there.

In terms of investment returns, the company has a present P/E ratio of 10.12, a respectable figure for any company without a great deal of obvious growth potential. Moreover, in terms of free cash flow, the situation is  even more attractive; the firm’s depreciation has been running ahead of its  capital expenditures by more than $40 million a year for the last three years, and also the firm records $10 million in noncash interest expense for the last few years owing to its convertible debt.  However, last year’s earnings were complicated by an unusually low tax rate. At any rate, adding back in these two noncash expenses and applying a normal tax rate produces a price/ free cash flow ratio of 9.24, an attractive prospect when combined with the safety of principle above.

(I will explain the convertible debt noncash expense as an aside. Damodaran reminds us that convertible debt should be treated as straight debt plus the value of the conversion option, and the FASB seems finally to have concurred in this view.  It requires companies to estimate the current discount of a nonconvertible bond yielding what the bond actually yields to a bond that pays market interest rates, and to amortize that discount over the lifetime of the bond. The conversion price is $54 a share, more than 50% above the company’s current price, but any rate the amortizing discount is not a real cash outlay, since the company actually received par for the bonds, not the discounted value.)

As the firm is a distributor, and does not make anything themselves, it should come as no surprise that it operates in a fairly competitive sector with fairly thin margins; their gross margin is 5.2% and their net margin is 0.8%, a situation that is replicated at least in their largest competitor, Ingram Micro (IM). In such a situation, it is clear that competitiveness comes from keeping capital requirements as low as possible, and Tech Data has managed to lower their long term debt since 2007 and also has just concluded a $100 million share buyback and announced another.

As stated above, the company does much of their business in the United States and Europe. They have engaged in several strategic acquisitions in the last few years. It is no doubt a concern that they are so exposed to Europe (between 50 and 60% of their total sales) in a time where the euro is weakening, but as they are resellers, and their inventory turnover period is only 26 days, whatever they lose by selling their inventory in euros is regained the next time they buy inventory. This, coupled with  judicious use of currency derivatives, has historically kept their foreign  exchange losses to a negligible amount.

I am aware that Ingram Micro, their largest competitor, is in much the same situation; their P/E ratio is within half a percent, and most of their other relevant characteristics (net profit margins, sales/assets, etc.), deviate from Tech Data’s by what amounts to a rounding error. However, Tech Data’s sales/inventory is 12.96, while Ingram Micro’s is 11.08, reflective of higher turnover rates. As I stated, with margins as tight as in this business the ability to do more with less is highly valuable (and I will point out that Ingram’s depreciation is equal to its capital expenditures, while Tech Data’s is higher) so although the two firms are so similar I would still give the edge to Tech Data. True, Ingram Micro is more geographically diverse, having made inroads into Latin America and Asia, but I’m not sure how much of that advantage will hold up in the face of competition for those areas either from Tech Data or from third parties.

At any rate, Tech Data offers excellent safety of principal and an enviable free cash flow, and should definitely be considered for portfolio inclusion.

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