Introduction
Scan Source Inc. is an international wholesale distributor of specialty technology products, marketing over 100,000 products from 250 vendors to over 30,000 reseller customers. The Company operates in 3 main segments:
1) Point-of-Sale (POS) and Barcode;
2) Communications (voice, video, and data);
3) Physical Security (video surveillance, access control, and wireless infrastructure)
The first segment markets the familiar bar coding technologies that enable electronic identification and data processing of a large group of products. Here, the Company sells bar code printers, hand-held and mounted laser scanners, data collection devices as well as magnetic stripe readers. These technologies, once relegated to areas like inventory control and warehousing, are now increasingly found in more sophisticated areas, such as health care. The POS business markets computer systems that have gone on to replace the old-styled cash registers and include terminals, monitors, receipt printers, pole displays, cash drawers, keyboards, among others.
The Communications unit delivers communications solutions which includes video and audio conferencing products; telephony solutions including Voice over IP (“VoIP”), and computer telephony building blocks. Finally, the Physical Security unit markets electronic security equipment, encompassing identification, access control, video surveillance, intrusion-related and wireless infrastructure products.
In addition to servicing the North American market, Scan Source has an international reach, with a distribution presence in Latin America and European markets.
Industry Overview
Scan Source’s annual report includes an insightful discussion on the evolution of distribution channels for specialty technology products. The report details a three-stage process that begins with manufacturers selling directly to end-users, later developing into a single-tier system, where we now find resellers acting as intermediaries between manufacturers and end-users. Finally, a two-tier system emerges with the introduction of wholesale distribution, with wholesalers purchasing directly from manufacturers and selling to resellers. Scan Source belongs to the wholesale distribution segment of the supply chain. Continued competition amongst manufacturers and resellers leads to outsourced opportunities for the wholesaler, as it is relied upon to deliver many of the value-added services traditionally performed by the other members of the supply chain. The wholesaler provides inventory management, financing, technical support, previously the domain of manufacturers, in addition to functions previously reserved for manufacturers, such as product assortment, delivery, inventory management, technical assistance and marketing.
Analysis of Business
Scan Source deals with reputable vendors such as Cisco, Epson, Honeywell, IBM, Motorola, among others. The Company markets products to 30,000 active value-added reseller accounts situated in North and Latin America, as well as Europe.
Scan Source has achieved double digit top line growth over the past decade, expanding from $850 million to over $3 billion in 2012 (Chart 1).
Over this time, earnings have followed suit, growing from $20 million to over $74 million, for an annual compounded rate of growth of 14% (Chart 2).
Strategically, the Company’s shift to international sales is beneficial, as it attracts higher gross margins (Table 1). Unfortunately, due to a weakened global economic environment, international gross margins have been hit disproportionately vis-à -vis domestic sales. Particularly in Latin America, where the Company is working on integrating its recent acquisition of CDC Brasil, a cooling economy and intensified competition has pushed margins to lower than expected levels. However, management remains committed to seeing these issues through.
On a return on equity basis, Scan Source delivers impressive returns compared to the competition, with only one rival able to generate better returns. But, on closer inspection, this excess return is generated with the use of leverage, as SNX has a 50% higher debt-to-equity ratio than Scan Source.
Going forward, I want to keep an eye on the Company’s quickness in converting revenues into cash the Company can then deploy to grow the business. In 2002, the Company required 49 days to convert the average dollar of revenue into readily available cash. Now, the average conversion time has climbed to 65 days (Chart 7). The Company explains that the recent decrease in inventory turnover was due to “higher inventory levels built up throughout fiscal 2012, as a result of favorable vendor pricing, longer lead times and anticipation for demand in certain products” [Source: 2012 Annual Report]. Management follows up by saying they have have begun to reduce inventories to “levels more consistent with our current volumes and weaker growth in Europe”. Over time, we want to make sure the cash conversion cycle stabilizes or, better, returns to historic averages.
Conclusion
Guided by a management team that has delivered impressive growth over the past decade and remains committed to achieving high returns on capital, investors are presented with a Company trading at an attractive valuation, with a reasonable margin of safety. Scan Source is not alone in facing today’s challenging economic environment, but is one of the few that has continued to impress during the ongoing malaise.
Also posted on my blog at: www.growingmargins.com
