ADDvantage Technologies Group (NASDAQ: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 (NASDAQ: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.