ADDvantage Technologies Group (AEY) has been the subject of a number of write-ups on value investing-oriented blogs the past month. With the stock only going down I thought that it was a good idea to do some research, and figure out if it is indeed an opportunity. ADDvantage is classified as a technology company, but that’s a bit misleading. They are distributors of spare parts and keep a big inventory in multiple locations: making them the company to do business with if broken equipment needs to be replaced in a hurry.
While I’m going to try to write an article that is readable without prior knowledge on the company, it is still a good idea to read the various cases presented online elsewhere. NZhedge has an excellent analysis including nice graphs such as the historical P/E and P/Tangible Book ratios. It’s important to realize that just because a write-up looks well researched and include nice graphs, it doesn’t make it true. Pretoria Investment and Whopper Investments both also provide a long case, while Oddball Stocks is more critical. Some key statistics on the company:
Last Price: 2.02
Shares outstanding: 10.21M
Market Cap: 20.62M
Trailing P/E (ttm): 7.73
Price/Book (mrq): 0.58
EV/EBITDA (ttm): 4.08
The basic long case behind AEY is the fact that the company is trading at $2.02 while NCAV is roughly $2.55 per share and is at the same time profitable with good returns on equity. The majority of this value sits in their inventories. They have $12 million in cash, $10 million in debt and an inventory valued at $26.7 million (and you also get the properties and equipment that’s on the books for $6.9 million for free). The inventory turnover ratio is currently around 1.4 which would imply that most of the companies assets could be converted to cash in a relative short period, giving the investor in AEY downside protection.
I actually think that’s a bit too simplistic and optimistic. The only scenario where it makes sense for the company to try to liquidate is when the business is strongly declining, and they are unable to sell sufficient amounts of network equipment. If that’s the case, liquidating the inventory without big losses is surely going to be a difficult exercise. Having a high inventory value provides a fake illusion of safety, because exactly at the moment that the safety is needed, it’s not there.
Correct me if I’m confused with another book, but I think it’s in "The Intelligent Investor" that Benjamin Graham talks about the liquidation value of property, such as factories, or real estate, such as a hotel. If a company is unable to turn a profit with it, odds are that it is simply not a profitable business to run a hotel at that spot, or produce product X. And having a factory that can produce a certain product that no-one wants doesn’t have a lot of value. It’s not quite the same with inventory, but the same principle applies. If the company is unable to sell it, it’s not going to have a lot of value.
Due to the business model of AEY they are also forced to keep significant inventories, so it’s also not really an asset that can be converted to cash without hurting the business (they have reduced inventories since the peak in 2008 slightly while income has dropped hard). So I think it is more appropriate to value the company on the cash flows that it is able to deliver. If we take historical averages the company is absolutely undervalued. Average return on equity for the past 10 years is almost 20 percent (great!), but things have been deteriorating since 2008 and the latest quarter was not pretty when the company reported $0.05 EPS. If we would translate that to P/E we would get a 10x ratio.
It seems to me that buying AEY is mainly betting on profits and margins returning to long-term averages. I don’t think that is necessarily a bad thing, but I don’t think there is a real margin of safety here. If the business deteriorates further a permanent loss of capital is in my mind a very real probability and at current levels it more or less looks like a fair price.