Description

Summary

Arena Bilgisayar is Turkey’s second-largest IT distributor. Superficially, the company appears undifferentiated, levered, and expensive. In reality, Arena is led by brilliant CEO Serkan Celik who has been responsible for the turnaround and growth of the core distribution business in addition to significant value creation from non-core ventures. The sale of one such venture is yet to be incorporated into the financials (and there is no analyst coverage) but results in a current valuation of 1x tangible book value and 5-7x P/E (depending on the rate of interest expense) - despite Arena’s runway of double-digit annual growth in USD and pre-tax returns on capital exceeding 35%. Coupled with Turkey’s return to orthodox monetary policy and an associated decline in inflation, an investment in Arena could return between 3-5x over the next 5 years.

History

Arena was founded in 1991 in Istanbul, Turkey, by Mehmet Betil, Ahmet Serter, Izi Kohen, and Alvi Mazon. The group had been working together at Karma International, which at the time was the leading computer components distributor in Europe and one of the largest in the world, and later decided to found Arena with the support of Karma’s management. Because Arena would distribute technology such as computers and servers while Karma was distributing only components, the two companies would not be direct competitors. In 1998, CHS Electronics acquired Karma but would file for bankruptcy one year later. As a result, Karma also went bankrupt, and Arena took over Karma’s contracts and began to grow its revenue considerably.

In 2010, Indian IT distributor Redington Group acquired a 49% stake in Arena. This was the company's first inorganic foray (they had built organically in India, Middle East, and Africa) because they believed they could not compete in a greenfield operation with the incumbents in Turkey (Indeks and Arena). 

Today, Arena has >400 employees (the figure will be closer to 300 following the non-core divestiture) working out of a nondescript office in the Göktürk neighborhood of Istanbul, where interestingly, each floor boasts a poster of a different inspirational figure in society (each of Martin Luther King, Jr., and Warren Buffett make an appearance!).

Management

A major moment in Arena’s history was the transition of Serkan Celik from CFO to CEO starting in 2018 (he had been the company’s CFO for the prior ten years). Since that time, the company has compounded revenues annually at 21%, gross profit at 24%, and operating profit at 61% (all in USD terms). Pre-tax return on capital has increased from 7% to 44%. In addition, Serkan’s intellectual curiosity and business acumen has led to the development of several non-core ventures – the most successful of which is in agreement to be sold for nearly $100m. He continues to innovate and believes that there is another opportunity in the making that could be yet larger (but until now cannot disclose the details).

Background

Distributors serve several important functions for vendors, particularly in emerging markets where vendors have little experience. First and foremost, distributors provide market access. When a company such as Apple wants to enter a market, it has little knowledge of the operating environment and instead must rely on a distributor. The distributor provides information about the competitive environment, creates relationships between Apple and its eventual customers, and provides Apple with real-time sales and inventory data. Second, distributors provide vendors with logistics, from breaking bulk (separating large deliveries into smaller parcels for specific customers), to the actual delivery of the products and reverse logistics (taking back returned products) when required – complicated functions that are better outsourced to a distributor. Third, distributors manage the significant credit risk of thousands of customers. Apple has neither the background nor the time to study the balance sheets of thousands of different customers in an esoteric market with whom it has never had a relationship. Distributors perform credit analysis on the customers and their respective currency hedging operations given the significant currency fluctuations in emerging markets. If a customer has committed to paying for a shipment in US dollars 60 days later, both the distributor and supplier (Apple) need to be sure that it will happen irrespective of any depreciation of the local currency.

Ultimately, IT distributors reduce costs for vendors and allow vendors to turn fixed costs into variable costs and minimize investment in working capital. The costs of warehousing, order processing, inventory logistics, product support (pre- and post-sales), account management, warranty claims, and so on are all reduced when outsourced to a distributor. Instead of holding large amounts of inventory in a warehouse, the supplier can outsource that function to a distributor. In addition, given their established relationships, knowledge of credit histories, and deep knowledge of the market and associated trends, distributors can avoid or minimize the bad debts and inventory write-downs that a direct vendor would otherwise face.

On the other side of the equation, distributors offer many advantages to buyers of IT products. They offer a significant proportion of products on demand, reducing the amount of inventory customers need to carry themselves. Distributors also provide better credit terms than the vendor, which reduces the working capital required for the business. Third, distributors provide delivery logistics and superior supply chain solutions. When a system integrator requires disparate products from different vendors, the IT distributor can provide all the products at once as opposed to a multitude of different shipments.

Valuation

Arena has a market cap of $140 million and will have net debt of approximately $20m following the receipt of proceeds from the divestiture. In addition, the company will continue to factor receivables for a total equivalent debt load of $70m, so the EV to consider is around $210m today.

The Turkish IT + mobile phone market is a bit larger than $5 billion and will likely double to around $10 billion in the next 7 years. Indeks Bilgisayar is the leading player with approximately 33% of the market, Arena has approximately 25%, Penta has approximately 12%, and Armada/Ingram has approximately 11% (the remaining 19-20% is fragmented).

Arena will grow faster than the market due to a combination of expansion in adjacent distributorships (such as renewable technologies), expansion into adjacent countries, and growth of non-core ventures. Operating income of $45m today can be $90m in 5 years, and net profit of $60m can be worth $400-600m in a normalized environment.

In terms of capital allocation, the company typically pays 1/3 of the profit as a dividend (though share repurchases may soon be considered) and re-invests the other 2/3. The profiling of the company’s debt in USD or TRY is yet to be determined and will have a significant impact on the rate of interest expense, which will affect the funds available to be allocated. Nevertheless, if we assume profit of $24m – around $8m will be paid as a dividend and $16m will be re-invested into inventory. This inventory can turn 10x and generate $160m of additional revenues at a 5% gross margin, which is $8m of incremental gross profit. Given the existing fixed cost base, the contribution margin of such re-investment will be higher than the existing margin and could result in $5m of incremental profit. Arena can therefore increase its margins over time with high returns on incremental capital.

Risks

The major risk is excessive competition in a commoditized industry. However, I have followed this industry for more than a decade now (I probably should have been following GPUs instead) and there appears to be a pleasant equilibrium that allows the major players to grow with the market and take share from the smaller players (due to strength in selection, price, convenience).

The other main risk relates to FX. There is always a risk of FX depreciation in Turkey, but the company operates in USD and Turkish people have been devoting an increasing portion of their income to technology (the vast majority of which must be imported). However, although the company’s functional currency is the USD, the tax authorities care about local currency (TRY). If Arena purchases a computer for $100 and sells it for $100 while the TRY depreciates from 30 to 40, the tax authorities will regard the computer as having been purchased for 3,000 TRY and sold for 4,000 TRY and therefore liable for a tax charge. This is why the company’s effective tax rate is negative during periods of heavy currency depreciation (current monetary orthodoxy has reduced this risk).

Catalyst

Proceeds from non-core divestiture entering the balance sheet later this year (significant leverage reduction)

Free cash flow generation

Potential share repurchases

Orthodox monetary policy