Description

Merisel (MSEL) is a quintessential cigar butt investment. MSEL is a company that has been through a massive restructuring, has decent prospects in its remaining line of business, and currently trades at a significant discount to net cash.

The company, as recently as 1999 had $4 billion in sales and competed toe to toe with full-line computer distributors such as Tech Data and Ingram Micro. They had a marginal reputation and suffered business setbacks when they lost the rights to distribute Microsoft and Sun products. Beginning in 2000 the company started to divest all of their hardware distribution lines. In Q1 2002 MSEL emerged as small but growing player in software license distribution.

My investment thesis for MSEL is based on three factors: its net cash position; the prospects and risks of its ongoing business; and the direction of the company as guided by its controlling shareholder.

Cash and Ratios (all data in thousands)
Shares outstanding: 7,707
Market Cap: 14,489
Long-term liabilities: 0
Cash: 48,373
Total current assets: 62,440
Net current assets: 33,023

Price/Cash: 0.287
Price/Net Current Assets: 0.42
Projected 2002 Price/Sales: 0.175

MSEL trades at a significant discount to net cash. Although the company’s software license distribution business is currently unprofitable (more on that later) the company has been able to maintain a stable net cash position over the past three quarters -- the period in which MSEL has existed in its current form. This minimal cash burn is the result of small operating losses, interest income from its sizable cash position, and some positive cash flows ensuing from the wind-down of older business lines.

Software license distribution does not require much working capital as there are minimal inventory requirements. MSEL has emerged from its restructuring as a very lean company with a substantial amount of excess cash. This cash position represents a substantial margin of safety.

Results from Operations
MSEL has reported a cumulative $0.13 per share in earnings over the first three quarters of 2002. However, these results overstates the profitability of the software distribution business as they are bolstered by discontinued operations, interest income, and one-time gross margin improvements from the wind-down of discontinued business lines.

The pro forma operating results for 2002 are as follows:
Q1 2002
Sales: 15,773
COS: 15,030
SGA: 1,970
Operating P/L: (1,227)
Gross Margin: 4.71%
Sales Growth vs. Q1 01: 215%

Q2 2002
Sales: 17,845
COS: 17,070
SGA: 2,128
Operating P/L: (1,353)
Gross Margin: 4.34%
Sales Growth vs. Q2 01: 115%

Q3 2002
Sales: 20,714
COS: 20,039
SGA: 2,475
Operating P/L: (1,800)
Gross Margin: 3.26%
Sales Growth vs. Q3 01: 83%

One of the only good things that can be said about MSEL’s P/L is that the top line is growing nicely. This is the result of the company finally focusing on the task at hand now that the restructuring is complete and the ongoing business clearly defined. They are starting from a very small base of sales and can probably increase sales 4-fold within the current infrastructure (read: no capital spending). This capacity for and likelihood of growth, as well as the minimal need for working capital are the bright spots in MSEL’s model.

There are significant risks as well. Although they sell products from about 10 manufacturers, MSEL has been highly dependant on two – Symantec and Network Associates whose products have respectively represented approximately 20% and 72% of sales. MSEL’s distribution relationship with a vendor I believe to be Symantec was terminated on August 31st. This significantly increases the company’s dependence on Network Associates products and could take a slice of about $4 million quarterly of the top line. However, the loss of a formal distribution arrangement does not preclude MSEL from dealing in Symantec products (or Microsoft for that matter), it just increases their costs as they obtain product from other distributors.

Another consideration is margin weakness. Software license distribution, like computer hardware distribution, is a very low margin business. Tech Data, Software Spectrum and Ingram Micro (three worthy comparisons) have had recent gross margins between 5% and 7%. MSEL’s pro forma gross margin has declined from 4.7% to 3.2% over the past three quarters despite significant sales volume growth. There is currently about $2.4 million of SG&A and $350,000 in preferred stock dividends to pay for quarterly. To cover that nut out of operations quarterly sales will have to more than double to $57 million while gross margins improve to 5%. Clearly MSEL has a bit of a haul before it reaches profitability. Once there, the economic returns on deployed capital should be decent given that the balance sheet is very asset-light.

Overall, I’m less than enthusiastic about the operating business. It’s a low margin, price competitive business with no competitive advantages. In addition, MSEL operational history is blemished. However, the cash drain should be minimal and the lackluster prospects of this business do not negate the investment thesis.

Controlling Shareholder
Stonington Partners is a private investment firm founded by former Merrill Lynch Capital Partners investment bankers. Through an entity Stonington owns about 65% of the company, holds two board seats, and acts as a controlling shareholder. There is significant synergy in this arrangement.

MSEL has two assets that are of major importance to Stonington. The first is the cash. The second is $260 million in NOL. It is the stated goal of the company to use its cash to fund strategic acquisitions and maximize the NOL. Stonington should be able to provide direction and opportunity in this regard. Owning MSEL is somewhat the equivalent of investing alongside a well-regarded private equity investor for 30 cents on the dollar.

The company is also buying in shares – 407,000 in the last six months. The float is extremely thin as Stonington owns 5,000,000 of 7,707,000 shares outstanding. The company’s willingness to reduce the already thin float could presage taking the company private. If a buyout is not in the cards, I would expect some M&A transaction in the near future.

Catalyst

A buyout, a synergistic M&A transaction, or further share buybacks should provide a catalyst to recognize the value of $4.28 net cash per MSEL share.