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How to Combine Business Analysis with 10-Year Financial Data

Geoff Gannon

Geoff Gannon

407 followers
Someone who reads my articles asked me this question:

Geoff,

I have looked at Addvantage Tech (AEY) in the past and came to the conclusion that it was cheap based on past performance. I then read your entire blog and most of your articles at GuruFocus.com and took another look.

I was trying to determine what the key driver was for AEY like you did with Microsoft in one of your articles where you wrote about Windows and Office being the primary drivers and the rest lost money for MSFT. I thought CATV spending would be the main driver for AEY but after looking at their revenues during the peak of the CATV capex spending, the numbers told a different story.

First, the numbers for revenue didn't match the higher capex spending in the industry in all years. I think this could be a factor of when their customers decided on upgrades and expansion and since AEY is a tiny company, there isn't a reason their revenues would have to match CATV industry spending.

Secondly, there is no correlation between higher revenues with higher FCF; the FCF seems to lag a year behind. I'm not sure if I'm looking for patterns where there aren't any or if this is because it takes time to receive the cash.

Wondering about your thoughts, as you've mentioned AEY before, and whether I'm correct or incorrect with my assumption that CATV spending is a primary driver for them.

Thanks for your time and great articles,

Matt

Great questions.

I think you’ll see the answer to both your questions – why doesn’t AEY’s sales performance track industry spending patterns better and why does higher revenue not immediately lead to higher free cash flow – are explained by one key aspect of AEY’s business.

Did you read ADDvantage Technologies (AEY)' 10-K? Especially the part about what they consider their competitive advantages. You’re right that normally a company in their business should see higher revenues, earnings, etc. at the same time. And that time should be when their customers are spending the most on equipment. This heaviest spending will be on new equipment, upgrades, etc.

But that really isn’t ADDvantage’s business. Let me explain.

Do you know anything about a company called Copart (CPRT)?

Great business. If you haven’t read about it, you should look into it. It’s a good name to know in the event stocks fall at some point in the future and offer you a chance to buy at a good P/E.

Anyway, Copart sells cars. That’s all it does. It has a tiny bit of the business in the UK that involves buying and selling cars. But normally it’s not a principal. It’s just an agent. A broker. It doesn’t ship cars. It doesn’t buy cars. It just stores and sells cars. Copart is a great business. This is especially true because they achieve very high returns on their net tangible investment even though they choose to own rather than leases most of their locations. They own acres and acres and acres of land on which they store cars. You can find the addresses for their locations on their website (each car has a location associated with it that will pop up if you click on the car). Copy and paste that location into Google Earth. You’ll be amazed at what you see. Anyway, they carry all this land which they then cover in cars and still they earn good returns on their tangible investment in the business without relying on the use of a lot of leases. So, it’s a very good and very interesting business.

Now, if I said Copart sold cars, you’d probably think that their revenues and earnings and free cash flow should rise and fall with U.S. car sales.

If you look at the past 10 years for Copart and for U.S. auto sales you’ll see this is not true. Not even a little bit.

Why is this?

Well, there’s this one tiny little detail I hid from you about Copart. Copart doesn’t sell new cars. Copart doesn’t sell used cars. Copart sells wrecked cars. They sell salvage.

So, if you think of Copart as being in the auto retail business – which they obviously are – you’ll have an entirely incorrect understanding of the company. That’s true even if you understand the wider industry of car dealers pretty well. Copart sells cars. But they aren’t a car dealer. Their business works differently. This is completely obvious if you listen to the company talk about themselves, or you read the 10-K, or maybe even if you read the Google Finance description:

Copart Inc. (Copart) is a provider of online auctions and vehicle remarketing services in the United States, Canada and the United Kingdom. The Company provides vehicle sellers with a range of services to process and sell vehicles over the Internet through its Virtual Bidding Second Generation Internet auction-style sales technology, which the Company refers to as VB2. Sellers are primarily insurance companies, but also include banks and financial institutions, charities, car dealerships, fleet operators and vehicle rental companies.”

Actually, that business description kind of sucks, doesn’t it? It doesn’t really tell you what Copart does. To understand the business you really need to understand four key facts:

· Sells cars over the Internet

· The cars are wrecks

· The sellers are insurers

· They physically store the wrecked cars

Once you understand these facts, you understand the business. Copart sells over the Internet. More than 25% of the buyers are actually foreigners. But they are selling wrecked cars. If you read the business description, yes it’ll say they do some other stuff. It’s minor. Insurers account for the vast majority of their business. And wrecks account for the vast majority of their business. They do sell some cars that were collateral on bad loans. They do sell some cars that were donated to charity. But let’s face it. They sell cars the public doesn’t want to see.

This is an out of sight out of mind business. If you use Google Earth to find their actual locations you’ll see this. Some of their locations might be fairly close to where a lot of people live. But they’re a bit out of the way and nicely hidden. It’s kind of like a garbage dump for cars. They need to put the locations fairly close to where people create the garbage. But they also need to hide their existence. And nobody wants two dumps in the same town. Likewise, nobody wants two huge lots of wrecked cars in their town.

Anyway, the actual way Copart’s business works – what determines their ROI, their moat, their growth, etc. – is all in those four factors:

· Sells cars over the Internet

· The cars are wrecks

· The sellers are insurers

· They physically store the wrecked cars

Those four factors aren’t really adequately described in the Google Finance business description. You need to take a couple minutes to forget about canned 10-year financials and business descriptions and snuggle up with a 10-K, CEO interview, newspaper article, investor presentation, blog post about the company, etc. Google’s search engine is a lot more useful than Google’s finance page for investors. Google Earth is helpful too.

Okay. So my point is just that a business is a business — it’s not an industry. Just because a company is categorized in an industry doesn’t mean it works like the other companies in the industry. For example, Amazon (AMZN) and Best Buy (BBY) and Walgreens (WAG) and Village Supermarket (VLGEA) are all retailers. But they are all really, really different retailers. Technology changes have vastly different influences on them. They have completely different business models. They are actually trying to do totally different things. And you would analyze them – especially starting with customer habits – totally differently.

You’re asking about AEY. I’ll get there. But I want to make a larger point. One of the first things you need to do – maybe the first thing you need to do when you look at a company – is figure out how it makes money. How do we get from an idea popping into the head of the customer to the cash register ringing and actual free cash flow being generated?

Village Supermarket (VLGEA) sells a lot of items that don’t make it any money. You may want to buy a can of soup from a Village store. That’s fine. They’re happy to sell you the soup. But they’re only happy to sell you the soup because they want your business. They want you in the store. They want you to put one of their Price Plus cards on your key chain and they want to scan that card. They want you in the store, building a habit, giving them data. They really don’t care about the soup. The soup doesn’t make them money. A grocery store cannot survive on soup alone. The customer makes them money. And cheap soup attracts customers.

But it may be that they actually want you buying meat and produce and seafood and baked goods and prepared food and using their pharmacy. They may in fact be using about 55% of their sales to drive the 45% of their sales where they actually hope to make money. They may figure that once you are in the store saving on the stuff sold in every grocery store of any size in America, you won’t have the willpower to just walk past the meat and the produce and seafood and the prepared foods. And they’ll make a good return on investment when you splurge for the high margin stuff.

Now, this part of Village’s plan may not be obvious – or even seem important – when you are looking at the 10-year financial statements. Because people buy groceries every day. And they buy meat and produce and seafood and baked goods and all the rest every day. So, Village will look the same year after year. And it’s not unless you walk the store or read the shareholder letter or talk to management that you’ll really see exactly what this business is all about.

With companies like Copart it’s different. If you thought Copart was just a car retailer – which it essentially is – you’d be baffled by why its sales aren’t related to total new car sales in the country. And you’d investigate.

That’s the situation at AEY. You are right about the industry they are in. But you may not yet be right about the business they are in. What is ADDvantage really trying to do?

If you look at their 10-K you’ll notice this little bit at the start of the fourth paragraph under “Background”:

“In addition to offering a broad range of new products, we also purchase and sell surplus-new and refurbished equipment that becomes available in the market as a result of cable operator system upgrades or an overstock in their warehouses. We maintain one of the industry's largest inventories of new and refurbished equipment, which allows us to deliver products to our customers within a short period of time.”

Bells should be ringing when you read that. Look at AEY’s business versus that of a competitor like Blonder Tongue (BDR). I’m just going to use GuruFocus data here. You can find the 10-year financial data for BDR here and the 10-year financial data for AEY here.

BDR (Gross Margin) AEY (Gross Margin)
2001 31.1% 48.0%
2002 27.2% 42.8%
2003 26.8% 38.8%
2004 32.1% 33.6%
2005 22.8% 31.9%
2006 34.6% 32.4%
2007 34.1% 29.4%
2008 32.8% 30.6%
2009 38.8% 30.5%
2010 40.2% 30.3%


It looks like BDR’s business has been getting better and AEY’s has been getting worse. Maybe, but the next table tells a different story:

BDR (Operating Margin) AEY (Operating Margin)
2001 6.1% 21.2%
2002 3.7% 18.6%
2003 (6.2%) 20.2%
2004 2.0% 19.8%
2005 (11.7%) 15.5%
2006 0.9% 19.1%
2007 (0.1%) 15.0%
2008 0.8% 13.6%
2009 0.7% 16.0%
2010 6.5% 12.9%


AEY’s business hasn’t been getting better. But what looked like two pretty comparable businesses a minute ago clearly are not. AEY was – and maybe still is – a much better business than Blonder Tongue.

Why?

Look at this very interesting table – I’ll present it the way GuruFocus presents it on the 10-year financial data as a percent of revenues:

BDR (Inventory/Sales) AEY (Inventory/Sales)
2001 56.3% 77.4%
2002 52.7% 66.4%
2003 58.1% 44.6%
2004 26.3% 50.4%
2005 26.4% 55.2%
2006 27.1% 47.9%
2007 25.9% 59.7%
2008 25.4% 78.5%
2009 28.0% 57.9%
2010 25.1% 67.7%


Wow. Look at that. AEY keeps way more inventory on hand than Blonder Tongue. Now when a company has a lower gross margin, inventory turns (Sales/Inventory), receivable turns (Sales/Receivables), or fixed asset turns (Sales/PPE) than its competitors and still earns a higher return on its investment – that’s a pretty interesting situation. It’s something to pay attention to.

AEY carries way more inventory relative to sales than BDR does. And yet...

BDR (Return on Assets) AEY (Return on Assets)
2001 1.9% 11.3%
2002 (12.4%) 14.1%
2003 (5.7%) 18.0%
2004 (8.2%) 14.8%
2005 (16.7%) 11.8%
2006 1.2% 15.2%
2007 (2.2%) 9.0%
2008 (1.5%) 6.1%
2009 0.3% 8.0%
2010 6.7% 4.8%


Now, AEY’s business has – as you expected – gotten a lot worse. If you look at the decline in ROA since The Great Recession – boy, that’s a huge hit AEY has taken. This company was posting double-digit ROAs in the first half of the 2000s.

So, what’s the story here?

Obviously, AEY’s business has a lot to do with its inventory. And it’s hard to understand AEY without understanding its inventory.

Others have noticed this. It’s not like I am the only person saying the company obviously has an unusual inventory situation, an unusual profitability history and an unusual business model.

For good write-ups on AEY see:

· Alpha Vulture: AEY

· NZ Hedge: AEY

· Pretoria Investment: AEY

· Whopper Investments: AEY

· Oddball Stocks: AEY

That should be enough reading material to keep you busy for a while.

As you can see, many bloggers noticed the “On Hand, On Demand” motto of the company. This is talked about in the company’s SEC reports. But it is also obvious in the 10-year financial results. In fact, the idea that AEY is built around on-demand inventory is obvious from a lot of different sources. Even looking at the company’s locations, the company’s history, etc., reinforces the view that this is a business about quickly getting small amounts of possibly not -quite-cutting-edge equipment out to cable companies who are trying to keep customers happy.

It makes sense. The loss of a cable subscriber has an extremely high cost to a cable company. The economic value of a current subscriber is immense. The cost to acquire a new one is also immense. You can’t afford to lose a customer when you don’t have to.

Would a customer leave a cable company if they didn’t fix a problem fast enough?

Yes. In fact, I had a bit of a personal experience with something that relates to AEY.

Back in New Jersey, my modem failed. This meant I didn’t have Internet access. Now, I also got phone and TV from the same company. They were getting revenue of well over $1,500 a year from me. Probably more like $2,000 a year. I called the cable company. I explained the problem. I made it clear I understood what the problem was – I just needed another modem. Unfortunately, there had been a bad storm (a terrible freak storm in fact) which had caused all sorts of problems throughout their service area. And they wouldn’t be able to get a repair guy to my house tomorrow.

Did I politely say: “Okay, Wednesday is fine?”

No. Internet service that is lost for a day or two at a time is worthless to me. You have to have someplace where you keep your equipment. Give me the address. I’ll pick up a new modem. You don’t even have to send a repair guy.

They said fine. Gave me the address. I had the Internet working again about an hour and a half later.

It was difficult getting them to forget about sending someone out and just giving me the replacement – until I said: I totally understand why you can’t send someone out here tomorrow. Can’t blame you for that. Now, please transfer me to someone who handles cancellations. Suddenly, it was very easy to get the address of where I could pick up a modem.

A cable company has a lot of ways to lose a customer. It’s very easy to annoy your customers. If you don’t have enough people answering the phones, if you don’t have enough people to send out and if you don’t have the right part right now.

It’s very expensive to risk losing anyone simply because you don’t have the right part right now. The economics of keeping every part on hand yourself are not great. The economics of losing customers over what is frankly really cheap equipment relative to what the customers you could lose over it are worth to you are even worse.

I would’ve paid for the modem myself. And I would’ve canceled if they didn’t let me pick it up. The issue was not cost. It was that I needed the Internet. I did not have the Internet. And if this company wasn’t going to get the Internet back for me – they were going to lose their customer.

In the modern world, your Internet provider is a utility. Not having the Internet is like not having lights. The electric company does not want people in the dark simply because they are missing some stupid part. Same thing with a cable company.

By the way, AEY mentions that they are not price competitive on large orders of new equipment and that they believe original equipment manufacturers are the preferred source for these sales. It’s smaller orders of older equipment – basically unplanned things their customers need now – where they think there is value in adding a middleman. They compete on logistics. That’s the business.

And that answers both your questions. When you look at free cash flow, look at additional investment in inventory. Inventory is what AEY focuses on. It’s what the business is about.

And when it comes to capital spending, remember that if a company wants to place a large, uniform order for new equipment – why would they use AEY? Why would they use a middleman? Why wouldn’t they just cut them out for those orders? Why deal with AEY when you can deal with Cisco (CSCO)?

Because you have a problem Cisco can’t fix. Companies don’t really make money by selling products. Companies make money by fixing problems.

Starbucks doesn’t make money off me because they can get me coffee beans at a great price. Starbucks makes money off me because buying their beans means I can wake up in the morning to the exact same routine – the exact same smell – and simultaneously avoid any risk of caffeine withdrawal. I pay Starbucks for convenience , consistency and caffeine. Not because I think the beans are worth what I pay. But because I don’t want my day screwed up over coffee.

So, you want to make sure that you are looking at what drives this specific company’s business and not just what drives industry sales.

It’s always most important to analyze the customer and the business first and the industry last. Industry analysis is usually important in the negative sense – telling you it’s a bad idea to buy any stock in the industry at a premium to book. Industry analysis is rarely necessary for a good business. Because the goodness of the business will be most obvious in the relationship between the company and its customers, not in the weak competitive position of the other players in the industry.

That’s not always true.

GEICO benefited a lot from other insurers already being stuck with agents. And Amazon (AMZN) benefited a lot from other retailers being wedded to their obsolete physical locations. Sometimes there is a pretty big first-mover disadvantage. In fact, later entrants get the benefit of having seen others blown sky high by the various land mines hidden in the industry. And businesses are generally less flexible than you expect. Once a company has grown into a certain form it is very hard to backtrack and change the organization to better adapt to today’s reality rather than yesterday’s.

Remember, evolution is an inherently conservative process. It conserves the traits that worked well in the past. It does not try to predict the future. And there is no guarantee that what worked well in the 1990s will work in the 2000s and what worked in the 2000s will work in the 2010s and so on. So a company may be well adapted to the business environment of 1998 and yet be a terrible fit for today’s environment.

Sometimes you will see things like that. You will see that a company’s competitors are badly positioned and that the company you are analyzing can take advantage of this.

But that’s not usually where you want to start your analysis. Usually, you want to start with what service the company is really providing for its customers.

In the case of AEY, the service provided is keeping inventory that might be needed but isn’t really wanted. That explains the business better than just knowing what industry they are in.

And I think it solves the mysteries you mentioned.

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About the author:

Geoff Gannon
Geoff Gannon


Rating: 4.1/5 (15 votes)

Comments

onthefringe
Onthefringe - 2 years ago
I don't believe your name is Geoff. Maybe it is Warren. Or maybe your last name is Ackman.
Topwine
Topwine - 2 years ago
Not bad for a college dropout !!

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