Description

Short Thesis: APCC has appreciated 24% in the last 5 trading days on the specious logic that private equity sponsors will target the company for an LBO, despite the fact that this makes no sense from a financial engineering point of view.  When the market realizes that no buyout is forthcoming, the stock should trade at or below its pre-LBO frenzy price.

LBO Likelihood: On Friday, September 8^th APCC closed at $16.96.  Since then, the stock is up over $4 to $20.97 on speculation that APCC could be a buyout candidate.  This speculation appears to be based on 2 factors: 1) Freescale Semiconductor’s disclosure last week that it is in talks with private equity sponsors and 2) In a letter dated September 11, 2006, Matrix Asset Advisors, a $1.6B large cap value fund that owns a 1.25% stake in APCC urged the board to "critically self-assess the proper corporate structure and direction" for the company. Matrix went on to say they “believe that a change in ownership structure, either through a private equity sale or a sale to a strategic buyer, is the best way to reap the efforts of your franchise development.” 

Thus APCC was anointed as the latest LBO candidate in the technology space much in the same vain that Jim Cramer attempted to make Broadcom out as a potential target for private equity on his program last night. The problem with this thinking, and thus the opportunity to short the stock, is that APCC does not appear to be a viable candidate for a buyout for one simple reason: valuation. The proposed Freescale buyout values that company at approximately 11.0x LTM EBITDA. I am in no way privy to the thinking of the Blackstone/Carlyle/TPG group that is buying Freescale, but I believe it is safe to assume they are utilizing various forms of leverage for about 7 turns of the total purchase price (roughly 65% of the purchase price) with the remainder financed with equity.

At its current valuation, APCC’s enterprise value is $3.5B or 17.5 x LTM EBITDA of approximately $200MM. If we assume an LBO at today’s price (ignoring for a moment that a premium would presumably be required) and that a transaction is financed with a 60/40 debt/equity split (which I believe is at the upper end of the amount of equity a sponsor might employ to finance this a buyout), we get to $2.1 in debt, or 10.5x trailing EBITDA, which is well past the point of unlikely.

Utilizing the sell-side consensus of $250MM in EBITDA and roughly $50MM in capex for 2007, we get to $200MM in discretionary EBITDA for next year. Assuming an 8% blended interest rate yields a total interest bill of $160MM, or an interest coverage ratio of less than 1.4x discretionary EBITDA to interest (my understanding is that current market conditions usually require a ratio of 2.0x or above). This would leave $40MM for discretionary capex and principal repayment.  While one could run a full LBO analysis to test the returns under various scenarios utilizing this capital structure, it really isn’t necessary – at 10.5x debt to EBITDA and less than 1.4x interest coverage, this deal is a non-starter.

Business Prospects: Without an LBO APCC is a company with mediocre margins that has shown little to no ability to leverage fixed costs despite nearly tripling sales over the last 10 years, with high single to low double digit operating margins and mid-teens returns on invested capital that generates little in the way of free cash flow.  This business trades for 24x next year’s EPS (and 14x EBITDA), which is likely an unrealistic estimate in the first place, given that management refused on the Q2 call to give any guidance as to when its ever increasing spending on sales and marketing initiatives and ongoing restructuring efforts would actually lead to a return to profit growth.

Other: On August 15^th, the company announced the retirement of former CEO Roger Dowdell “effective immediately.” Dowdell was succeeed on an interim basis by Rob Johnson, who has been at the company since 1997, when his family owned software business was acquired by APCC. Johnson has numerous family members still employed at APCC, including 3 brothers, a brother-in-law, and his father, who works as a consultant for the company. APCC makes no effort to hide these connections and in fact listed them in the 8-K announcing his interim appointment. I would note that the lack of a proven management team at the helm of APCC further reduces the chance of an LBO – sponsors are in the business of finding and teaming with great managers to run good businesses, not buying mediocre businesses with bad management teams (I did this once, it was not fun).

Valuation: At 37.5x 2006E EPS, investors are either a) counting on a buyout b) looking past 2006 to 2007E EPS of $.87 (24.1x) or c) both of the above. I see no reason for this stock to receive such a high multiple, particularly given the lack of clarity around the 2007 estimates. For the last five years, APCC has averaged a trailing P/E ratio of approximately 25, which would yield a price of approximately $13.25 (25x LTM EPS of $0.53).  In the latest 10-Q, APCC noted that “We are confident that the strong year-over-year revenue growth can be attributed to what we believe is a healthy macro-economic environment for IT spending.”  Obviously, the sale of computer power management systems and ancillary products is highly levered to the IT spending cycle. Should that cycle slow, future earnings would have to come under pressure.

Risks:

-          Shareholder activism.  Other activists could get involved in this situation, drawn in by Matrix’s first shot across the bow. I would note that in an interview with Reuters, Matrix CIO David Katz said: "We wanted to send a strong message from a significant shareholder.  Our intention is not to become more active in that regard.  We wanted to make it clear that we think they have to do better for shareholders. We're not going to be the guys that force the issue."

-          Company sale. I am comfortable that this company will not be bought by a private equity firm. I do not have a view as to whether a strategic buyer might be interested. This does not seem like a company that will be swooped up by a strategic for a big premium – far more likely that the board would put out a press release about “exploring strategic alternatives.”  The stock would be up 10% that day (but this might be a good time to short more).

-          Balance sheet. APCC is debt free, with some $500MM+ in net cash. The board authorized a $200MM buyback in the first quarter, $129MM of which had been utilized at the end of the 2^nd quarter. Further buybacks or even a leveraged buyback could put upward pressure on the stock.

Catalyst