Description

By going long this stub, you are buying a reasonable-quality business run by shareholder-friendly mgmt at about 5X EV/FCF. Due to this discount & the inherent leverage in stub trades, I think the upside is considerable. Please note that the market cap above is Fayrewood’s mkt cap expressed in USD, and the share price is the stub price expressed in pence. The stub is capitalized at USD 13M, but the 58.8 figure is a better indicator of liquidity, and I didn’t want folks to pass this by for the wrong reason. That said, I’ll admit that the borrow on Computerlinks is a bit tight, so the stub may not be appropriate for some of the bigger fish that swim in the VIC pond.

Fayrewood is a UK-based IT distributor of computers, peripherals, and consumables to small/mid sized enterprises and large retailers throughout much of Western Europe. It owns 51% of a Germany-based IT distributor named Computerlinks. Despite what you might think, there isn’t much operational overlap between the businesses. Back in the late ‘90s, management saw an opportunity to invest early-stage in a business they understood (for obvious reasons), and it worked out quite well.

I call the core Fayrewood business “reasonable-quality” because – on the one hand - the distribution game is generally characterized by razor thin (1-1.5%) profit margins, making execution a constant worry. On the other hand, the company is run by insiders who own 30% of shares outstanding and have a good record of value creation. In addition, FAYREWOOD recently added UMD, a Spanish distributor with roughly 3% margins. UMD margins are higher due to 1) a couple of exclusive distribution deals, and 2) the lower labor costs in Spain. UMD complements Fayrewood's original business nicely, and while the latter is seeing only tiny growth, the former is growing at a good but manageable clip. I think they got a bargain on the UMD purchase, btw.

The European IT distribution business has three notable characteristics: 1) growth potential is decent since the penetration rate of PCs and Internet access is significantly lower than in the US, both for homes and offices, 2) the industry is much less concentrated than in the US, and 3) IT vendors tend to rely on distributors to do more training and support than in the US, owing to the more heterogeneous nature of the European market.

My claim that management has a good record of creating value is based on a comparison of the capital added to the business since around 1998 and the resulting increase in FCF generation. Between debt, capex, and acquisitions, FAYREWOOD has put about GBP 38.5M into the business. Over the same period, “look-through” FCF has gone from about 1.2M to about 6.1M, an increase of roughly 5M. Also, they eat their own cooking, given the 30% insider stake. Insiders bought a few shares last year at prices ranging from 40p to 62p, then bought 24% of a tiny share issue at 69p that was done in early August.

So let’s talk numbers. The core Fayrewood business generated roughly GBP 2.4M of FCF in the year ended April 30, ’01. This number is after all capex, excludes changes in WC, and includes tax-adjusted interest expense. Likewise, the company was slightly FCF negative in the year ended April 30, ’02 (obviously a tough year for the industry). Fayrewood recently changed its fiscal year end to coincide with Computerlinks, so the year ended Dec 31, 02 was an 8-month year which included 4 months of UMD results. Annualizing the 8-month results, Fayrewood FCF was GBP 3.9M for the period. 1H03 results included the contribution from UMD for the full period, so annualized FCF jumped to GBP 5.8M. There was nothing screwy about margins that would cause me to think this is an aberration, but capex was a bit light, so let’s call it GBP 5M. Note that 1H is the seasonally weak half, but let’s be conservative and forget that I said that.

Fayrewood has GBP 17M of credit facility debt, so the stub EV is GBP 24.8M. Sure, IT distribution ain’t See’s Candies, but 5X is just too cheap. By the way, I think the balance sheet is ok. EBIT/interest is about 5X. Management paid down a good chunk of debt in ’02 and may pay down more. Let’s also not forget that the GBP 31M stake in Computerlinks is a reasonably fungible asset that could be at least partially monetized in a pinch.

Computerlinks has roughly 5% profit margins (high for a distributor) since it’s products are fairly complex pieces of software that require the training it provides. This and the small/moderate growth rate make me think this business deserves a 12X FCF multiple. Add that to the GBP 9.6M of net cash and Fayrewood’s 51% stake should be worth about GBP 31M. At 9X FCF the core Fayrewood part should be worth GBP 40M. So, I think the enterprise is worth 76M in total, vs the current EV of 52M. The stub is now trading at 7.7M, whereas it would trade north of 27M if the EV reached my appraisal value.

Why is this cheap? My guess is 1) it's small, 2) it's confusing, due to the stake in Computerlinks. Regarding the second point, Fayrewood is not a pure-play, since it is both a distributor and a passive investor in another distributor. Further, Fayrewood financials are in UK GAAP, while CPX financials are in International Accounting Standards (IAS). Prior to December 31st 2002, each company had a different fiscal year end. Basically, it takes some work to figure out just how much the core Fayrewood business contributed prior to Dec 31, 2002. (I’m happy to walk you through it, however.) Management tells me that institutional investors (the few that are paying attention) have shied away due to the small size and the non-pure play status. I love hearing this – as Buffett says, one of the secrets in life is weak competition.

I also think that a simple long position in Fayrewood should work out fairly well, but I think the stub is cheaper.

Bloomberg ticker: FWY LN
www.fayrewood.co.uk
www.computerlinks.de

Catalyst

FY03 (ending Dec 31, 03) will be the first year that fully includes the UMD acquisition, as well as being the first 12-month period in which Fayrewood and Computerlinks have the same fiscal year-end. This should make the FCF generation much more clear.