Description
PC Connection (PCCC) is a midsize distributor of IT products selling very close to its tangible book value. It has a consistent history of profitability and is an undervalued participant in an unloved industry. The thesis is that there is a floor on the share price based on a high quality tangible book value and that the shares could reasonably double sometime in the next 2-3 years assuming a decent economic environment. There is Net Cash of almost $1.50 per share. Net-Net is $5.60/share. Book Value excluding goodwill and other intangibles is $6.44. 2008 EPS should be around $0.80 - $0.85, compared to last year’s $0.85. Next year’s EPS will probably be in the $0.50 - $1.00 range. Given the economic uncertainty, it’s hard to be more precise than that. Free Cash Flow averaged a bit less than Net Earnings over the past three years. EV/EBITDA = 3.2 (trailing) and is less than comps and a recent buyout of smaller competitor Zones by its founder. The shares are reasonably liquid, with 90,000 changing hands daily. Bid/Ask spread is typically a few pennies.
The firm started out as one of the first mail order catalogs for the newly developed Personal Computer market back in 1982. Old time geeks like me remember those days with fondness. While the catalog still exists, these days the focus is less on individual consumers. The revenue ($1.8 Billion) split is Small/Medium Business (SMB at 55% of first half revenues), Large Account (28%), and Public Sector (17%). Individual consumers are only 6% of revenues and are included in SMB.
Market response to the latest earnings report was negative. Their gross margins actually improved but they have a consistent problem with SG&A, despite its reduction being a large factor in the executive compensation plan. This seems to be their biggest execution issue.
I’d expect the nest 2-3 quarters to be weak based upon the recent earnings warnings from Dell and Ingram. Still, there’s good reason to believe that PCCC will weather this downturn well, due to the strong balance sheet and the fact that the senior management team has been in the industry since before the last big industry downturn (2000-2003) and knows how to deal with it. They’ve been profitable every year since their 1998 IPO, even after taking into account relatively small writeoffs (certainly smaller than that of many other IT distributors). The CEO is Patricia Gallup, one of the founders, and thus can be expected to manage for the long-term. However, there is no moat and this is a cutthroat business.
CDW is one of the elephants in the DMR (Direct Marketing Reseller) space. It was acquired by private equity last year at much higher multiples than companies sell at now. I consider that valuation to be an outlier that is not applicable to the current environment. At first, in July 2007, CDW stated that it expected to continue to be a consolidator of the industry. Beginning in the fourth quarter of 2007, stock prices of several publicly traded companies in the DMR sector began to decline due to diminishing operating results as well as declining multiples. In December 2007, CDW announced that credit conditions would limit its ability to pursue significant acquisitions of greater than $50 million for at least 18 to 24 months. Between the beginning of the fourth quarter of 2007 and the end of the first quarter of 2008, average stock trading prices of public companies in the DMR sector declined by more than 35%.
Insight Enterprises is a larger competitor of PCCC with revenues of $4.9B. About one-third of their operations are non-US. Last quarter Insight recorded a $314 million pretax goodwill impairment, and the comps I present below add that back for EBITDA and earnings. Zones (ZONS) is a smaller competitor of PCCC. It’s a nice comp however, since it too has a CEO that is the controlling shareholder. In July, after a quarter of significant sales decline, ZONS accepted a bid by its CEO for $8.65 per share in cash. This is especially interesting since the same person had made a bid for ZONS in 2003 at $1.00 per share, so its not as if this guy has a record of making outlandishly high bids.
_all TTM ZONS PCCC NSIT
EV/EBITDA 5.0 3.2 5.4
EV/E 8.4 6.0 11.3
EV/FCF 3.2 3.5 10.4
P/Tangible Book 1.7 1.0 1.7
Note: ZONS inventory financing treated as debt.
PCCC’s ROE is around 10%, smaller than I would like, even after taking into account their cash balances. Still, it is better than that of Ingram, Tech Data, and several direct competitors. Inventory Turns are running around 24x vs 22x last year so there is relatively little risk of unusual obsolescence. These turns mean that the quality of this balance sheet item is good. PCCC’s obsolescence charges have historically ranged between $6.5 million and $7.1 million per annum. Historically, there have been no unusual charges precipitated by specific technological or forecast issues. For comparison, both Tech Data and Ingram have turns of around 13, with Zones at 27. DSOs were 45 days for the second quarter of 2008, compared to 42 days for the second quarter of 2007. The increase in DSOs is due to the higher percentage of sales derived from the public sector. These generally have longer payment terms than business customers.
Their biggest suppliers are Tech Data, Ingram, and HP. This presents some risks because they could move to cut out PCCC as a middleman. However, these 3 companies are optimized to serve resellers and retailers and the skill set required to service these organizations is very different than those required to serve SMB, government, and larger corporations. Of course this could change and there is some indication that Tech Data is trying to increase its presence with SMB. I’m actually more worried that Best Buy would expand their Geek Squad offerings to more directly compete with the services that PCCC offers, such as fixed asset tracking and disposition, configuration, and training. Best Buy would be a formidable competitor, especially in the SMB space. A company like Amazon could also increase its presence in this space.
Gallup and the other co-founder have put their shares in a Voting Trust, which owns 64% of the outstanding shares. They are co-trustees and must agree on voting their shares in the Trust. However, they are permitted to sell their shares to anyone else, subject to a right of first-refusal by the other Trustee. Thus, the Voting Trust is not an absolute bar to the firm being sold, even if one of the founders disagrees. On the other hand, if both of the Trustees agree to sell the firm at a marginal price, it would be a struggle for other shareholders to challenge it.
Back in 1997, prior to going public, PCCC entered into a long-term leasing arrangement of the Corporate HQ from the founders. The terms may perhaps have been overly generous to the founders. I’d be more concerned about it, but there doesn’t seem to have been any material related party transactions since then. Compensation is not overly piggy.
For me, the biggest draw of PCCC is the margin of safety as represented by the current minimal markup over tangible book value for PCCC. There is minimal debt and a lot of cash. Despite better operating metrics, it seems to be valued lower than many peers and as if it were about to go out of business. I concede that the Zones CEO may have been tempted to sandbag the company’s performance to gain a lower purchase price. On the other hand, PCCC should get a premium to ZONS, since its greater size and consistent profitability gives it more viability. PCCC’s valuation discount to NSIT seems excessive if it is just due to PCCC’s concentrated ownership, especially considering that things are much different now than they were when CDW was bought at an elevated price. That said, there is no reason to believe that the PCCC cofounders are planning to take the company private. This is not going to be a ten-bagger, but it seems to have an attractive risk/reward ratio over a 2-3 year horizon.
Catalyst
If the world ends, the strongest balance sheet wins. If the world doesn’t end, everything goes up.