Undervalued Wayside Technology Is Still Winning The Battle Between Margins And Sales

| About: Wayside Technology (WSTG)

Summary

The feared margin declines are offset by increasing sales.

Very healthy balance sheet and long-term oriented stable management.

Attractive valuation implying ~30% upside.

Wayside Technology (NASDAQ:WSTG) announced its first quarter results yesterday. I would like to use that as an opportunity to take a closer look at this small company. After it popped up on my initial radar, based on its high Return on Invested Capital and Earnings Yield combination (aka Joel Greenblatt's Magic Formula), I initiated a small long position in the stock in November 2014. After 16 months and 6 quarterly earnings updates, the stock has not moved very much. In this article, I discuss why I believe this company is still undervalued and as a result has 30% upside potential.

The Margin Fear is Unjustified

Wayside is a software reseller, operating as the middle man between producers (such as Intel, Microsoft, Lenovo etc.) and other resellers as well as corporate end users. This is a difficult position in the overall supply chain, especially in the fast-paced software market. An often heard argument therefore is that companies in this area will get squeezed out over time due to constant pressure on the margins. If we look at Wayside's operating margin, a decline over time is observable. However, the magnitude thereof is not nearly as dramatic as often expressed. The 40 bps drop in operating margin has been more than offset by revenues, that doubled over that same period.

Although these are backward looking numbers, their dynamics illustrate a tradeoff that I believe is vital for the success of this (and similar) companies. When margins decrease, the firm's profitability decreases. On the other hand, it essentially becomes cheaper to its customers, enabling it to obtain more business. As long as the company is able to keep the net effect of these two positives, there is no need to worry. Wayside has been able to steadily keep its head above water, resulting in ever increasing earnings per share (10y avg. growth rate of 17%).

The valuation is (still) attractive

A standard DCF valuation shows that the company is undervalued at current levels. Wayside has no long term debt, $24 million in cash ($4.60 per share), and a working capital of $31 million ($5.86 per share). Table 1 gives a general overview of the most important DCF assumptions.

WACC

9%

Annual revenue growth

14.8%

Operating Margin

1.8%

Reinvestment ratio

10%

Click to enlarge

With no debt, the WACC is equal to the cost of equity, which is set at 9%, implying a 6.5-7% risk premium on top of the risk free rate. This is somewhat higher than its historical beta allows, but compensates for the fact that this company is fairly small and has a relatively concentrated business. Annual revenue growth is set equal to its ten-year historical average, or 14.8%. Operating margins are assumed to decline another 40 bps to 1.8%, while the portion of EBIT reinvested equals is set at 10%, in line with its historical average. These parameters give a value per share of $21.60, or 31% above the current market price. Hence, this is in a scenario with declining margins and a high cost of capital. Table 2 shows a sensitivity analysis for these different parameters.

WACC

value

Operating Margin

value

Revenue growth

value

7%

$23.74

2.2%

$26.09

25%

$28.88

8%

$22.55

2.0%

$23.85

20%

$24.87

9%

$21.60

1.8%

$21.60

15%

$21.71

10%

$20.41

1.6%

$19.36

10%

$19.25

11%

$19.45

1.4%

$17.11

5%

$17.34

Click to enlarge

As table 2 illustrates, the input parameters have to be altered to extreme measures to get the share price close to its current levels. In order for a price of $16.50 to be fair value, one would have to assume no growth at all, declining margins and a relatively high WACC. Consequently, if all goes bad, investors still end up with a company priced at around fair value. Alternatively, if the company continues its steady path of the last 10 years, there is room for at least 30% appreciation.

Strong Management

Simon Nynens has been the company's CEO for over 10 years now. In that decade, he has proven to acknowledge the risk of the business itself, combining it with a conservative growth policy and a long term focus. The company obtains a decent return on invested capital (15%), and where possible, capital is returned to shareholders with both buybacks and dividends. Wayside has over 400,000 shares left in its current buyback program plan. In addition, the company keeps a steady dividend policy, which has been rising since 2015 to a current $0.68 per share. This results in a dividend yield of around 4% at a payout ratio of a little over 50%. Again, lots of safety margin and potential room for growth.

Risks

I believe the primary risk of this company to be customer dependency. There are two clients making up more than 10% of sales and the biggest five customers account for more than 50%. However, this has been the case for many years, and there are no indications for a disruption in one of these client relations. On the contrary, smaller margins combined with increased sales will only stimulate more business. Other risks are the volatility of the business it's operating in and fierce competition. With respect to the former, that risk is mainly located at the producer, that has to incorporate the fast changes into its product. Fierce competition is a constant factor, which has been successfully faced over the long run. There are no clear indications for a sudden change in this regard.

Conclusion

I still believe Wayside is an underappreciated company trading at a sizable discount. The biggest source for this is the fear of deteriorating margins. The source of these declines is not in increased costs, but in the company effectively becoming cheaper for its customers. At the same time (and likely as a result of this development), Wayside has been able to increase revenues which has more than offset declined margins. A DCF valuation illustrates that fair value is, even if conservatively measured, 30% higher than the current price. Add to it the strong management in place and a healthy balance sheet with no debt and enough cash, this company will fare very well in the years to come. Oh, and if it stays undervalued, you get paid a 4% dividend for the wait. I consider Wayside a strong buy.

Disclosure: I am/we are long WSTG.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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