Acquisition Of CDW Highlights Challenges Of Shorting On Valuation Alone

Madison Dearborn Partners, LLC private equity purchase of CDW Corporation (CDWC) last week caught me by surprise, especially as I was short CDW stock at the time. For those interested, you can read the CDW press release (PDF, 36k).

In an earlier article, I indicated that I believed CDW was overvalued relative to its peers. While that might have been true, the private equity deal takes the discussion out of the theoretical realm. One of the challenges of shorting on valuation alone is that valuation can go higher yet.

Probably the best and most succinct summary of the CDW transaction was expressed Thursday by Bill Fleckenstein of FleckensteinCapital.com:

Deals these days make no sense, and I think that the CDW one will rank right up there with Freescale Semiconductor, in terms of ideas that should have been passed on. To pay 1 times sales for a company that has no products, and in essence just owns a mailing list and a couple of distribution centers, seems to me to be the height of folly -- a refrain that I often find myself repeating lately.

In situations like this, you simply take your lumps and move on. One of the challenges in shorting, especially in a strong bull market, is to find a catalyst that will drive the stock lower. I had no catalyst, but instead believed that CDW's valuation would in time drift lower and more in line with that of its competitors.

The shareholders of CDW have done well. The company does appear to be well managed, and even though I was short the stock, I was and am a content customer.

Disclosure: I have no positions in CDW.

Comments

[AlanBrochstein]

Thanks for pointing me to that Fleckenstein quote. Once again, he speaks strongly about things he knows not. CDWC is a lot more than "a mailing list and two distribution centers", and he should know better. You, as a happy customer, obviously do. When we first bought CDWC in 2001 at my former employer, the big concern was barriers to entry. We believed, evidently correctly, that their scale and processes would allow them to prosper. The company proved to have a better business model than DELL. You don't have to be vertically integrated to serve customers.

[Kevin Stecyk]

I appreciate your comment Alan. Nobody bats a 1000 in this business, and Fleckenstein and I are no exception.

While I can't speak for Fleck's complete thoughts, I had compared CDWC to other companies such as Insight Enterprises, Inc., (NSIT) which is very similar to CDWC. As a person who shops for computer peripherals, would often compare prices on both sites. I usually found that CDWC had a better organized website, but slightly higher prices. Recently, however, I found CDWC had better prices too. I suspect that the pricing situation changes from time to time.

Given that these two companies are in the same industry, I expected that both would trade in the same general neighborhood, using the usual parameters. But CDWC traded significantly higher. As a customer, I found the biggest difference between the two companies was the website. Could that be fixed? Is CDWC's moat that impenetrable?

Obviously I bet the wrong way. It'll happen again.

<i>The company proved to have a better business model than DELL. You don't have to be vertically integrated to serve customers.</i>

No question Dell has struggled. I am not so sure that their direct to consumer business model is at fault. Rather, I suspect it has more to do with customer satisfaction, cost structure, and bulky and ugly designs. Apple Inc. (AAPL) is a study in contrast.

I agree with you that you don't have to be vertically integrated.

Again, thank you for your comment.

[AlanBrochstein]

I wasn't criticizing you for your short - I make mistakes all the time! I was really just responding to the Fleckenstein quote, which was highly uninformed.

NSIT has never been able to get the kinds of margins that CDWC got. It couldn't afford the kind of advertising that CDWC was able to do. It couldn't get the same incentives from the manufacturers. They pursued ventures that detracted management's efforts on its core business.

[Josh Stern]

The concept "Don't short without a catalyst" is repeated so commonly that it is a cliche. But I honestly don't know why someone who was shorting based on valuation would focus on CDWC when there are so many more absurd valuations everywhere one looks. As an example, consider CCI - it is absurdly overvalued (price to sales of 11.5X and losing money), overleveraged, has no economic moat, decling GAAP and operating income, yet it continues to rise like a moonshot. I've got LEAP puts on it but only think of them as portfolio insurance against a market meltdown, not something I actually expect to make money on.

[Kevin Stecyk]

<i>The concept "Don't short without a catalyst" is repeated so commonly that it is a cliche.</i>

True enough, it is a common refrain. But at least with a catalyst, either you're right and you win. Or you're wrong and you cover. There is a decisive moment when you know where you stand. Shorting on valuation, you <i>hope</i>... the market comes to its senses and sees things as you do. While the phase, <i>Don't short without a catalyst</i> is cliché, at least there is some value to it.

There are many seemingly overvalued stocks. Those of us that engage in shorting pick stocks that we feel we have a reasonable shot at being correct. The short community as a whole is having a difficult time. As you point out, you have a favorite short that continues to defy gravity and logic. One thing for sure, though, shorting is both challenging and dangerous.

Thank you for your comment.

[Josh Stern]

IMO, a good starting place for a discussion of a short position is a thesis about the expected return from the position and why one believes in that thesis. Since a high percentage of shorts are put on as hedges (either for the trader or for someone else), one can't assume that the trader's expected return for holding the position L length of time is better than a money market return over that period (or that it is even positive). So I am saying that your rational for shorting CDWC was missing from your article. Did you expect a meaningfully positive return from your short or was it just intended as a hedge for other positions in the computer hardware industry? Surely valuation per se wasn't the main basis for the trade because you didn't pick one of the most overvalued stocks. My example is that, by contrast, I've attempted to pick one of the most overvalued stocks but still regard my trade as a hedge rather than something with positive expected value.

[Kevin Stecyk]

Josh, your starting point is as good as any. And you're right, many shorts are put on as hedges.

My rationale for the short is missing? No, my rationale was that I believed--wrongly it turns out--that CDWC was overvalued compared to its peers. It's a rather straightforward rationale.

Was CDWC the most overvalued stock in universe? No, most defiantly not. I follow a limited number of stocks that interest me. CDWC was in my universe of technology stocks, and it was one that I thought was susceptible.

Did I have a hedge against it? Not directly, though I do hold other computer and technology related stocks. So in theory, if computer and software technology companies took a thumpin, CDWC would have formed part of a hedge. But that wasn't my rationale. I never performed a correlation analysis, nor did I make any attempt to hedge the same exposure short as I have long.

Did I expect a meaningful positive return? Yes, most definitely. I thought computer related stocks in general were due to correct because of lackluster demand. There's been nothing really new in the PC world for quite some time. Vista was and is not setting the world on fire. While most companies are doing well, there is no desire by most to spend aggressively on technology. In fact, the largest increases in sales by CDWC was not by the private sector, but rather the government sector. In summary, I thought computer related stocks in general would suffer and CDWC even more so.

You've picked one of the most overvalued stocks in general and chose some leaps as a hedge. Generally I don't like that strategy because of the decay of the put option. As time passes, the put option becomes less valuable. So you might even be correct in that the stock is overvalued and gradually drifts down in time, you might still loose on the trade. But I am sure you have thought that through and understand the risks and rewards.

Is picking the most overvalued stock the best strategy? Not in my opinion. One, they can go higher and often do. Two, they can often be momentum darlings and don't trade in relation to valuation. Three, there can be large short positions that result in squeezes, preventing the stock from being properly priced. Four, the analyst community might be in love with the stock and will continue to bull it higher. Have a look at Yahoo Analyst Opinion for your stock: finance.yahoo.com/q/ao.... And on and on. So I don't necessarily think that targeting the highest overvalued company guarantees you a win.

Instead, develop a broad portfolio of stocks, and if you believe that one of the companies you follow--and you can't follow them all--is a strong short candidate, then decide if you want to play the game or not.

The same applies to going long. Do I buy the most undervalued companies? No, I have a broad portfolio with a higher than average concentration in energy and precious metals. That fits with my belief that the commodities bull run has a long ways to go and that oil is not as plentiful as we wish it were. Given that one cannot predict the future price of commodities, I can't say that I have or haven't picked the most undervalued stocks.

I hope that helps Josh.

Thank you for your comment.

[Josh Stern]

I understand from the clarification above that you mainly picked CDWC to short because you were negative on the computer industry and felt CDWC to be one of the most overvalued stocks there. Clearly that is a lot different than shorting based on valuation per se, though I'd argued that CDWC doesn't stand out as overvalued (forward P/E less than 20, ROA of 15%, trading at less than 1x sales is not super high valuation compared to, say, the disk drive manufacturers that also sell a commodity).

Re: LEAPS vs. Short - obviously depends on the goal and the option pricing and other market conditions. For something like this where the goal is to hedge and "out of the money" doesn't mean much since it could go down 75% and still be overvalued, I liked LEAPS better.

Analysts - I pay attention to analyst earnings estimates, but regard their buy/sell ratings as a mildly contrarian indicator - i.e. prefer to be long something less loved and short something more loved in terms of buy/sell ratings, since the only future upgrades or downgrades matter in terms of affecting the price.

[Kevin Stecyk]

NSIT

Market Cap: $1.1B
Enterprise Value: $1.3B
Revenue: $4.2B
Income: $65.5M
Forward PE: 12

CDWC
Market Cap: $6.74B
Enterprise Value: $5.8B
Revenue: $7.1B
Income: $281M
Forward PE: 20


So for nearly double the revenue, CDWC gets a 6-7X multiple on market cap and an over 4 multiple on Enterprise value. Granted CDWC enjoys larger margins and is likely a better run company, as Alan earlier pointed out. In my view--again, the wrong view--being a retailer in computer goods is nothing outlandish. NSIT could have hired some key talent where it is lacking and embarked on a fierce retailing war.

I don't see the comparison between a disk drive manufacturer and a retailer. If CDWC only sold disk drives, then I'd be more sympathetic.

Anyway, it appears that we agree to disagree, and that's okay. That's what makes markets.

Thank you for your comment. :-)

[Josh Stern]

You should take off 12% for CDWC numbers before the buyout. Also, I don't understand the point of comparing it only to NSIT unless you are actually doing a paired trade, and here is another important number: Operating margin - NSIT 2.52%, CDWC 6.35%. That's a world of difference in either mail order or retailing.

I'm not saying CDWC was a good buyout value; but IMO it wasn't a good example to make a general point about shorting based on valuation.

[Kevin Stecyk]

Here, this post might help you: www.speciousargument.c...

I didn't compare to <i>just NSIT</i> and, as stated, it was not part of a paired trade. While CDWC enjoys higher operating margins, there is significant incentive for others to catch up. And again, much of CDWC growth was/is from government. If government spending slows or if another competitor gets super aggressive.

Anyway, I think we've beaten this one to a pulp.

Good luck on your short. :-)

[Kevin Stecyk]

Whoops...

<i>If government spending slows or if another competitor gets super aggressive</i>, CDWC would be vulnerable.