What gives them a moat
AEY is a distributor. Basically, they buy inventory from OEMs (mainly Motorola or Cisco), store it, and then sell it to the cable company. Distribution is traditionally a no-moat business, and AEY competes for sales with a variety of distributors and even the OEMs themselves.
So what sets AEY apart? They pursue an “on hand, on demand” business model. This means is that AEY maintains a huge inventory position so that customers who need equipment on short notice know that they can turn to AEY and have equipment delivered immediately. AEY has developed a reputation as the company to go to for equipment in a pinch, and their employees have a reputation of working with customers to get them equipment during crisis and outages. In other words, AEY is the go-to firm when a cable company needs equipment immediately, and this reputation allows them to charge a premium for their product.
Is that really a moat?
Originally, I was a bit hesitant of management’s claims that this business model could create a moat and earn fantastic returns on capital. I wondered why another distributor couldn’t copy the business model, or if AEY could really charge a premium for simply having products available on demand.
However, a quick glance at the numbers reveals that management’s claims are true: AEY’s strategy is generating outstanding returns. Over the past nine years, AEY has averaged pre-tax returns on tangible assets (operating income / tangible assets) of 20.2%. To put this in perspective, these returns would put them in the top 30% of businesses in the S&P 500 in terms of returns on capital.
Once you think about it, this begins to make sense. In a crisis (normally an outage caused by some form of inclement weather, like a flood or tornado), cable companies need parts and they need them immediately if they want to get service back online. They don’t have time to call around asking for price quotes or figuring out who has which parts they need. Even if they did have time, they need immediate delivery, so they’re not going to mess around with terms or order from someone who needs to ship cross country. They’re going to call the industry standard who they know will give them a fair price, have all the parts they need, and get the parts to them in a hurry… And that standard is AEY.
So what are you paying for a business that has historically and consistently generated returns on assets better than most of the S&P?
Really, not much. In the past 12 months, AEY has earned just over $5 million in operating income. At its current price of $2.24, AEY has an EV of $23.3 million. That’s an EV / EBIT ratio of just 4.66x. Note that AEY has a small amount of net debt, so EV is just a smidge higher than market cap.
And AEY is even cheaper if you look at them on a historical basis. Over the past nine years, they’ve averaged operating income of just under $8 million. On that basis, you could buy them today for under 3x EV / historical EBIT. Warren Buffett has said he liked to buy into great enterprises when they trade for under 7x EV / normalized EBIT. While AEY might not have as strong a moat as a traditional Buffett investment like Coke (KO), it is a business with a proven competitive moat trading for much, much less than the multiple the Oracle of Omaha has said he looks for in a buy.
Let’s take a look at AEY from a different perspective: the balance sheet. AEY has tangible book value of $3.30 per share and net current assets (current assets minus all liabilities) of $2.57 per share. At today’s close of $2.24, AEY is trading for 0.87x net current asset value and about two-thirds of tangible book.
Stop and think about that for a second. AEY has averaged 20% pre-tax ROA for the past nine years. Without employing any debt, that would translate into post-tax returns on equity between 15-20%. AEY does employ some debt, so their actual figure has come in higher, but for arguments sake let’s keep it at 15-20%. Businesses that earn 15-20% returns on equity deserve to trade for a multiple of book value, not a fraction of book value!
At this point, you’re probably asking what the catch is. There’s no way a business earning 20% returns on assets is trading for a fraction of book value.
That’s true. AEY’s core customers are the cable companies, and in the wake of the great recession they’ve slashed expenditures and delayed equipment repairs and upgrades. This caution has cut into AEY’s revenues, which has reduced their profits and returns on assets. In the past few years, AEY’s returns on assets have trended down from their average of 20% to the 12-14% range.
Obviously, this is a bit of a concern. But the fact is, despite the recession and sales reduction, AEY is still profitable and still earning nice returns on assets. That 14% return on asset number is interesting — it’s the median pre-tax return on assets by an S&P 500 company. The average company in the S&P 500 trades for a multiple of book value — I’d argue AEY deserves to do the same.
Just for fun, let’s take a look at what AEY’s current assets could earn in a more normalized environment by thinking about what they’ve historically earned on their assets.
Let’s start by looking at their current margins versus historical margins. Their current operating margins come in at 13% (the lowest margin rate in the past decade, btw) versus an average of 16.9% over the past nine years. If they could just get back to their historical margin, EBIT would increase from $5 million to $6.5 million.
Now let’s start thinking about their current asset utilization compared to how they’ve historically utilized their assets. As mentioned earlier, the key to AEY’s business is their inventory. It makes up the bulk of their assets (currently more than 50%) and is their big selling point to customers. Currently, they have $26.7 million in assets. Over the past nine years, their average inventory turnover has been 1.75x (they’re currently sitting at 1.44x). If they did that today, their revenue would come in at $47.8 million (versus $38.6 million trailing run rate). At their current operating margins, that’d translate to EBIT of $6.1 million. If they increased their margin to historical levels, that’d be $7.9 million in operating income.
Both of those are a bit more in-depth way of looking at the company. You could also look at their current asset turnover rate versus their historic rate, their current return on assets versus their historic rate, etc. But all of these metrics will point you to one thing: AEY’s business is currently depressed, and a snap back to more normalized levels would yield huge increases in both revenues and profits, making an already cheap business even cheaper.
It’s always nerve racking to invest in a micro-cap company. Let’s assess the risks to an investment in AEY.
Obviously, you have to worry about management. A lot of micro-cap companies are run like private companies and management treats them as their own personal piggy banks. That’s not the case here. The chairman and the CEO (two brothers) have run the company for over 25 years and combined own almost 50% of shares outstanding. They have a solid history of building shareholder value (shareholder equity has almost doubled over the past 10 years) and a deep list of contacts in the industry. Management is definitely a strength here.
You’ve also got to be a bit worried about a small company’s financing. It’s not easy for these small companies to raise capital if the economy takes a negative turn. That’s not really a concern with AEY — they have almost no net debt, and current assets alone dwarf all liabilities by more than 2.25x. Plus, they own several pieces of real estate that are unencumbered by debt and have an untapped line of credit available to them. In other words, the company can easily finance itself even if sales depress further from today’s already low levels.
Finally, more than 50% of the company’s assets are in the form of inventory. The risk of some of this inventory being overvalued or becoming obsolete represents the major worry in investing in AEY. However, investors have two reasons to believe this isn’t on the horizon.
First, about two-thirds of the company’s inventory consists of new products. As AEY has noted on several conference calls and investor presentations, almost all of their inventory consists of exclusively hardware and/or equipment with almost no software in it. This inventory is very slow to grow obsolete and has years of demand even after it’s no longer being produced. Management likes to tell the story of a customer looking for a piece of equipment that had been discontinued well over five years ago who buys from AEY (at healthy margins!) because no other company still carries that piece.
Second, if anything, management has been too conservative with expensing obsolete inventory. Their reserve for obsolete equipment has historically been much, much greater than the actual expenses they’ve incurred for writing of inventory. As a matter of fact, AEY currently has a reserve for future write offs of $2.3 million, which represents almost 10% of their current inventory level and is just slightly less than the total level of inventory write offs over the past five years. If management is this conservative with writing inventory off, I feel pretty confident that they are managing their inventory effectively.
In conclusion, AEY really represents a “heads I win a little, tails I win a lot” situation. You’re investing with a management team with a track record of creating value and with many “magic formula” characteristics at decidedly “Ben Graham” prices. A simple return to tangible book value would yield almost 50% upside, and if business picks up as the economy recovers it’s not a stretch to see that stock tripling from here.
Disclosure- Long AEY