Description

Summary

Advanced Marketing Services, Inc. (MKT) is creating the first global book wholesale and distribution network. Founded in 1982, AMS focused on servicing warehouse membership clubs and currently dominates this niche with 94% of the U.S. warehouse club business. Recognizing the need to diversify, AMS has grown its wholesale customer list to include office-product stores, computer stores, Internet retailers, specialty retailers and traditional bookstores.

In addition to growing its customer base, AMS has entered the higher-margin market segments of contract distribution and publishing. Through strategic acquisitions, most notably the acquisition of Publishers Group West in January 2002, AMS is now a leading distributor for independent publishers.

AMS's international reach has been expanding as well, challenging the notion that book distribution is a local business. AMS has international operations in the U.K., Mexico, Australia and Singapore. AMS also has a 25% interest in Canada's Raincoast Books, the exclusive Canadian distributor of Harry Potter titles (the latest volume is due out on June 21, 2003).

The effort to diversify beyond warehouse clubs and focus on higher-margin businesses has had a direct impact on AMS's financials. ROE has increased from 7.3% in FY93 (AMS's fiscal year ends on March 31) to 17.5% in FY02. A look at multi-year ROE averages also reflects the steady improvement in AMS's operations:

3-year average ROE 18.2%
5-year average ROE 16.7%
10-year average ROE 12.2%

AMS has had no debt until drawing down a line of credit in 2002. The balance currently stands at $12mm. As a result, ROIC is nearly equal to ROE.

Margins have expanded as well, as shown below:

FY02 FY93
Gross margin 15.7% 8.4%
Operating margin 5.0% 1.7%
Net Margin 3.1% 1.1%

EPS has compounded annually at 29% over the past 5 years and 22% over the past 3 years. In terms of valuation, AMS is selling near a 52-week low. The stock closed on Friday 1-24-03 at $10.67, giving it a multiple of 9.2x FY02 EPS and 11.4x TTM (depressed) EPS. Other figures:

P/S .25x
P/BV 1.5x
Market Cap. $202.4mm
TEV $201mm


Background

The wholesale business. The need for AMS is simple. There are over 135,000 new books published each year. There are over 1,000,000 titles in print. Out of this selection, a warehouse club typically stocks maybe 150 to 200 titles. How do they select the titles with the highest volume potential? How do they manage their inventory? What about deliveries? Are they going to pay the freight and handling costs to receive relatively small shipments of books from numerous vendors on a weekly basis?

The standard bulk product purchasing and handling procedures employed by the warehouse clubs to keep their costs to a bare minimum don't work for their book programs. Book programs require specialty purchasing and handling procedures. Books are valuable SKUs, which makes the added effort in stocking them worthwhile. Think of the size of a hardcover or mass market paperback book. They take up a small amount of space in relation to their selling price.

Thus AMS set out to become the leading book supplier to the warehouse club industry. As a result, sales to warehouse membership clubs accounted for 78% of AMS's FY02 revenue, down from 94% in FY96 (reflecting AMS's diversification efforts). Costco and Sam's Club, AMS's two largest customers, accounted for 71% of FY02 revenue.

Wholesale customers outside of the warehouse club industry include Office Depot, Staples, Fry's, The Borders Group, and Amazon.com. AMS already handles paperback shipments to Borders's Waldenbooks division, and is on track to supply all of Borders's superstores with mass market paperbacks by the end of FY03.

A key value-added service AMS provides to its customers is its product selection advice. Retailers want books that sell, and sell fast. AMS has developed an inventory management software system that has dropped book returns by over 20% since it was implemented. AMS's Vendor Managed Inventory software analyzes years of sales data to forecast future sales by title and location. Customers' marketing priorities and selling environments are also considered, along with customer base and regional characteristics.

AMS posted a customer return rate of 28% in FY97. In FY02 this figure was down to 22%. Just as AMS accepts returns from its customers, publishers selling to AMS also accept returns. 87% of the books AMS purchased in 2002 were returnable. This practice significantly lowers the risk of inventory obsolescence. The remaining 13% of the books AMS purchased were non-returnable or partially returnable, based on higher purchase discounts.

Inventory is a killer in the book business (even if the books are returnable), as it is in any business. It is critical for AMS to help facilitate a high turnover rate. Product selection contributes to turnover, but so does distribution. AMS has five regional distribution facilities across the U.S. to assure rapid delivery to its customers, increasing turnover rates and lowering handling and holding costs. AMS's U.S. distribution center square footage has doubled since FY00, reflecting growth in its business and a shift to a higher percentage of sales coming from the distribution business (which requires more warehouse space).

As for AMS itself, inventory turns increased from 4.2 times in FY97 to 5 times in FY02.

The distribution business. The difference between wholesaling and distributing is exclusivity. Wholesalers buy and resell books on a non-exclusive basis. Distributors possess exclusive contracts with publishers. As a result, their margins are higher. They provide warehousing, credit and collections, sales and marketing and even printing services. AMS, through PGW, is the largest independent contract distributor for small-to-medium size publishers in North America.

As for AMS's international expansion efforts, in FY98 the U.S. accounted for 97% of sales. By FY02 that figure had dropped to 92% of sales.


Valuation

There's no question that AMS has grown rapidly over the past 3, 5 and 7 year periods (EPS CAGRs of approximately 22%, 29% and 30%). 5-year sales growth stands at 13.6% and 5-year cash flow growth stands at 28%. (AMS announced weak earnings in both July 2002 and January 2003, causing its stock to fall to current levels.) Reduced consumer spending has impacted AMS's earnings, as well as significant costs related to management information systems upgrades necessary to support future growth initiatives.

However, even when factoring in a 30% reduction in EPS for FY03, AMS is selling at a very attractive valuation. Run a range of conservative assumptions through a discounted cash flow model. Cut AMS's 3-year growth rate in half to 11%. Start from a FY03 EPS base of .82. After nine years, revert to 6.5% growth. Employ a 10.5% discount factor and a 4% capitalization rate. At $10.67/share, AMS is selling at 40% of intrinsic value. Lower the initial growth rate by 20%. Run the model again. AMS is still selling at under 50% of intrinsic value. The point is, the valuation modeled from a DCFA should be obvious. A range of conservative estimates produces one simple fact: AMS is significantly undervalued.


Cash Flow

It is important to examine AMS's cash flow from operations and free cash flow. A basic presentation of cash flows reveals:

FY02 FY01 FY00 FY99 FY98
Net Income 23.1 20.8 17.1 12.5 9.1
Depreciation 4.6 3.9 2.8 2.2 1.5
Other 3.8 8 2.7 3.8 6
Changes in W. C. -18.7 -10.1 -9.2 -17.9 3.8
Cash from Operations 12.7 22.6 13.4 .7 20.3

Capex -14.9 -10.6 -6.7 -3.3 -2.1
Dividends -.8 -.7 -.7 -.6 0

Free Cash Flow -3 11.3 6 -3.2 18.2

Notice the hit cash flow from operations takes from changes in working capital. Remember that, in accordance with standard industry practice, AMS has the right to return the overwhelming majority of the books it purchases, significantly lowering the risk of inventory obsolescence. In terms of sustainability of cash flows, inventory increases, a significant component in the decrease of working capital, should legitimately be excluded.

Also, notice the significant increase in capex over the past several years. The majority of these expenditures relate to capital investments, not maintenance capex. AMS has nearly completed a multi-year enterprise-level MIS upgrade designed to enhance its systems capabilities relating to its expansion efforts. Costs of this upgrade have impacted free cash flows and earnings negatively. In addition to MIS enhancements, AMS has continued to make capital investments in the expansion of its distribution capacity. And AMS continues to mainly use internal funds to pay for its expansion into higher-margin businesses.

In FY02, of the $14.9mm spent on capex, approximately 79% related to capital investments and 21% related to ongoing expenditures (breakdown: $8.4mm related to MIS enhancements, $3.4mm related to distribution center expansions and $3.1mm related to ongoing maintenance capex).

Taking another look at the cash flow statement, by adding back the increase in inventory and adding back the 79% of capex that related to capital investments to examine sustainability of free cash flow and to account for capex (investments) vs. capex (maintenance), we see in FY02:


FY02
Net Income 23.1
Depreciation 4.6
Other 3.8
Changes in W.C. -18.7
Inventory (add-back) 12
Cash from Operations 24.8

Capex -14.9
Capex (add-back) 11.8
Dividends -.8

Free Cash Flow 20.9

Notice the significant difference between the two calculations (20.9mm vs. -3mm).


Competitors

AMS's main competitors are Ingram Industries, Baker & Taylor and Chas. Levy. Ingram, a private company, is one of the largest wholesale book distributors in the U.S. B&T, a private company 85% owned by investment firm The Carlyle Group, is the leading book supplier to libraries. Chas. Levy, a private company, is a wholesale distributor of magazines and books.


Risk Factor

Although AMS has been diversifying its business, 78% of sales are generated from warehouse membership clubs (Costco, Sam's Club and BJ's). AMS does not have a long-term or exclusive purchase commitment with any of its warehouse club customers. That being said, AMS began operations as a supplier to warehouse clubs and has established solid and long-lasting relationships with these customers, leading to its dominant position in the industry.


Other

As of March 31, 2002 (according to AMS's FY02 Proxy) all executive officers and directors as a group owned 23.3% of the common stock outstanding. There are 718,725 shares exercisable at an average price of $7.27 and 89,626 shares exercisable at an average price of $1.83 under AMS's two stock option plans. Combined, they represent 4.3% of the 18,965,000 current shares outstanding.

Institutional ownership stands at 59%. Short interest as a percent of float stood at 3.26% on 12-9-02.


Conclusion

AMS has been investing, and will continue to invest, in its future to achieve its goal of possessing the first global book distribution network. AMS has been an above-average grower that has steadily strengthened its financial strength and metrics through its expansion into higher-margin market segments. AMS has experienced a shortfall in earnings during a significantly weakened consumer spending environment. AMS is positioned well for the future and, at current valuations, makes for a very attractive investment.


Catalyst

1) The return of consumer spending.
2) Continued growth of its business model.
3) Continued strengthening of its fundamentals.
4) Valuation.

Catalyst

1) The return of consumer spending.
2) Continued growth of its business model.
3) Continued strengthening of its fundamentals.
4) Valuation.