(Note: This article was initially published in August on my website but is still relevant since the price still hovers around 40. There is also the potential sale of the TS Segment which I have already published here but will post an update if the deal closes.)
Avnet Inc. (AVT, Financial) distributes electronic components, computer and storage products and provides IT Solution and Services. The company operates in two segments:
- Electronics Marketing (EM)Â –Â Markets and sells semiconductors and other embedded devices for electronic component manufacturers.
- Technology Solutions (TS) – Works with business partners to deliver more effective and efficient supply chain and IT life cycle solutions.
Five-year price chart
Organic sales rose 0.7% in the first quarter and fell 5.5% and 7.2% in the second and third quarters. The company has a long history of profitability (except noncash write-downs) and trades at TTM price-earnings (P/E) of 9.85x.
Risks
Customer risk
IBM (IBM, Financial) accounted for 11% of the company's revenues last year. There is an apparent risk that IBM could out of the blue decide to switch to a different distributor. I don't see this as a problem, however, because:
- Distributors tend to have little operating leverage.
- When a client is this significant to a company, it tends to provide lower than average margins to that company. The loss of the customer won't be particularly disastrous to the company from a bottom line perspective as it would from the top line.
- This is typical in the industry. Large technology tends to diversify among distributors to avoid any significant delays in the event one fails.
Cloud obsolescence
Avnet distributes physical computer software, and given the industry trend toward the cloud, it'll prove to be ultimately detrimental. The other side of the coin is that the computer products are concentrated within the technology solutions segment. Below are unadorned breakdowns of revenue and operating income for both EM and TS:
Within the operating expenses, there is "corporate," which is overhead. The operating income numbers for each segment in fiscal 2015 were $797.4 million for EM, $325.7 million for TS and $150.6 million for corporate. If we conservatively net out TS and overhead, we'd be left with a total operating income of $321.1 million. Assuming a 30% tax rate, net income would equal $224.7 Â million. That would give Avnet a P/E of 23, on par with the Standard & Poor's 500. The above is extremely conservative and doesn't take the following into account:
- The TS segment also contains enterprise computing servers, storage, hard disk drives, microprocessors, motherboards, DRAMs and other services along with software. Although management doesn't break this number out, I'm doubtful software accounts for even half of the TS segment. Arrow Electronics (ARW, Financial), a direct competitor, breaks this down according to last fiscal year's annual report:
Within the global ECS business segment, approximately 39% consist of software, 35% of the company's sales consist of storage, 9% consist of proprietary servers, 9% consist of industry standard servers and 8% consist of other products and services.
The ECS segment is comparatively equivalent to Avnet's TS segment. In 2015, approximately 62% of the company's sales were from the global components business segment and approximately 38% of the company's sales were from the global ECS business segment – they literally have the same revenue proportions. A more appropriate number to use for software is 39%; the 100% number is quite conservative.
- Time value of money – While the software portion may be declining, it isn't gone and will still provide cash flows to the company. The above conservatively assumes that the software portion goes away today.
Catalyst
Easier comps within the semiconductor industry
The EM segment is approximately 81% semiconductor.
The semiconductor industry is facing severe headwinds today, and the revenue declines should make next year's comps easier to beat. My target for this is the second quarter – that quarter was the first and sharpest sales drop. Sales in China fell 10.3% in fiscal 2016 after rising 7% in fiscal 2015, and the company, like others that have been affected by the China slowdown, faces easier comps so we might see some stabilization in the second quarter of fiscal 2017.
Balance sheet, absolute and relative valuation
Avnet
The company carries $1 billion in cash and has $9 billion in current assets (Including cash). Excluding cash, we have $8 billion. Liabilities total $6.5 billion. If we subtract the $6.5 billion from $8 billion, we get $1.5 billion. This means that net of cash, the company would still have $1.5 billion worth of equity after subtracting all liabilities and also conservatively assuming that the company's noncurrent assets are worth nothing. Now, if we subtract the $1 billion from the company's $5.1 billion market cap, we get $4.1 billion. The company made $507 million last year for a 12.7% earnings yield or a P/E of 7.87 which is relatively cheap compared to both its competitors and the general market.
Arrow Electronics
But to compare them, Arrow, too, has $9 billion in current assets. If you net the $500 million cash, we have $8.5 billion. Liabilities total $8.5 billion, which means you can eliminate them, but without any equity for a margin of safety. The company made $500 million last year, the market cap today is $6 billion, or $5.5 billion net of cash for a P/E of 11 or earnings yield of 9.1%.
Both
Avnet has $1.5 billion of equity after netting current assets without cash; Arrow has none. This $1.5 billion is significant because it's about 30% of Avnet's market cap. Today's buyer would get $1.5 billion of extra equity plus the $1 billion in cash, or $2.5 billion liquid equity compared to Arrow's $500 million liquid equity. Avnet has a market cap of $5.1 billion, while arrow has a market cap of $6 billion. This is provided that Arrow's revenues have been relatively stable over the past year while Avnet's plunged.
Avnet is indeed cheaper for a reason, but if we do see revenues stabilized, the valuation gap should close. If we don't see revenues stabilize, then market already expects disaster from Avnet anyway. So this is more of an "If I'm right, I win big; if I'm wrong, I don't lose much" scenario. The intelligent investor would be receiving over 10% earnings yield today from Avnet while we wait for better days.
Conclusion
There's no solid catalyst for Avnet, but I believe the company could also potentially be an acquisition target given its valuation. My cost basis on this position is $40.45, and my price target is $55. I have set a limit order to increase this by 20% if the stock falls below $40.
Disclosure: I am long Avnet.
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