Description

5/31/05
Stock Price $4.84 Cash $6.5mm 52-Week H/L $26.20/$3.67 ADV 206k
Shs Out 11.6mm Debt $51.8mm Sales (FY04) $997mm
MVE $56.1mm TEV $101.4mm Tang. BV $52.5mm

MALL is a leading rapid response direct marketer of computer hardware, software, peripherals and electronics. The Company offers products and services to business, government and educational institutions as well as individual consumers.

On April 11, 2005, MALL spun-out a money-losing, high growth business called eCOST (ECST), which is a multi-category Internet retailer of new, refurbished, and close-out computer products, home and houseware products, watches and jewelry and other consumer products. Each holder of PC Mall common stock received approximately 1.2 shares of ECST common stock. MALL traded for about $12.90 just prior to the spin, and on April 12, 2005 it traded for $5.09, while ECST traded for about $5.97. Unfortunately for shareholders, the spin-off coincided with poor 1Q05 performance for both companies and as of May 31, MALL is $4.84 and ECST is $3.16 for a total value of about $8.63 to original MALL shareholders, or a loss of about 30% post-spin. The stock (including ECST) traded for about $24.00 as recently as January 2005.

The opportunity here is the parent stub or the core MALL business. MALL has a TEV of about $101mm and had sales of $997mm and EBIT of about $7mm in FY04 (hidden by the ECST losses). The Company has a NAV of at least $7.00 per share, and reasonable assumptions about forward sales growth and/or margin expansion indicate the stock could be worth as much as $16.00 within the next 24 months. Therefore, MALL is currently trading at a significant discount to intrinsic value and offers a tremendous amount of upside with fairly limited downside.

Specifically, MALL is attractive for the following reasons:
*Trading @ discount to NAV: MALL is a profitable business in an attractive segment of the IT industry trading at about TBV. But book does not take into account the value of other assets that would have to be reproduced to compete effectively with MALL, such as its active customer list, its brand recognition (the company has been in business since 1988 and has spent about $20mm per year on advertising in each of the last three years), and investment it its direct sales platform and distribution infrastructure. When these assets are factored in with very conservative assumptions, MALL has a NAV of at least $7.00 - $9.00 per share.
*Sales Growth: Sales in the core MALL business grew by 13%, 12%, and 24% in FY04, FY03, and FY02 respectively. As compared to its main competitors/public comps, MALL’s salesforce is relatively unseasoned, and there is a high correlation between experience and sales production. Increased rep experience over the next 12 months + should translate to significant sales growth for MALL. Further, direct marketers currently comprise only about 5% of the total IT market but nonetheless have many advantages over the other business models in the space. Therefore MALL and its competitors are well positioned to grow substantially for the foreseeable future through market share expansion and overall IT market growth.
*Management Focus On Profitability: Before the end of 1Q05, management was preoccupied with the ECST spin-off. MALL’s core business was also EBIT positive and management was admittedly more focused on investing in sale infrastructure and capturing market share (not to mention SOX) than expanding profitability. But in a meeting with management on 5/24/05, MALL’s CEO stated that management is now highly focused on profitability and intends to reach a 2% EBIT margin even if sales do not grow during FY05—he plans to get there via “low hanging fruit” expense cuts and getting back to gross margins the core business consistently achieved prior to 1Q05 (see below). This is encouraging in that even limited success cutting costs could lead to substantially higher EBIT levels during the next 12 months which would significantly increase the value of the stock.
*Significant Inside Ownership: Management controls about 20% of the stock, including the CEO/Founder’s stake of about 17%.

Industry & Competition
In 2004, the U.S. IT product market was about $145bn size. The growth of demand for IT products is the subject of much analysis and debate in the investment community and is closely related to valuations of everything from enterprise software companies to semiconductor and LCD manufacturers. The overall market has not grown much over the past several years (with some parts contracting) and estimates for IT as a whole range from 2% annual growth for the next several years to as high as 10%. Most agree that smaller-scale hardware and software products that comprise the SMB market are the safest part of the market as small-ticket, maintenance purchases of notebook computers, LAN routers, and Microsoft software licenses don’t require extensive decision making or capital budgeting and are not characterized by deep investment cycles.

But given the sheer size of the market, MALL and its direct competitors can continue to grow sales significantly simply by capturing market share from other formats. MALL’s competitors fall into the following four categories: Direct Marketers (top four companies comprise < 5% of the market), Value-Added Resellers (VARs), Manufacturers, and traditional retailers. Local and regional VAR’s have traditionally been responsible for the majority of IT sales and some analysts say they still comprise about 70% of the market. VARs are finding it increasingly difficult to compete with the prices offered by direct marketers as the easy access to prices of thousands of products from competitors on the web creates tremendous pricing transparency. Further, software/hardware configurations are growing increasingly standardized and interoperable so a single IT manager at a company can handle most of the duties that a VAR was necessary for in the past.

Typical retailers for SMB’s seeking hardware and software are Comp USA (taken private in 2000), Staples, and to a lesser extent the big-box consumer electronics companies such as Best Buy and Circuit City. Prices and selection tend to be inferior at retail locations vs. direct marketers and salespeople are not nearly as knowledgeable or familiar with the buyer’s configuration as account reps at direct marketers. Many hardware manufacturers now sell direct to consumers via websites (Ex., toshibadirect.com, IBM.com) and telephone sales centers, and several have pursued a retail location strategy (Ex., Apple, Gateway). Dell Computer sells only directly to consumers and businesses. These models are certainly challenge the IT direct marketing category and much has been made of them but they still represent only a fraction of total sales in the industry. One of the key benefits of buying from a direct marketer is the full spectrum of product choice both in terms of different offerings for the same type of product (ex., notebook computer, wireless LAN router) but also the one-stop-shopping benefit of being able to meet all IT needs with one seller. For example, while Dell might be a highly desirable choice for PCs for a small business from a value standpoint, other needs such as specialized types of software or network hardware (ex., a firewall device) may be simply unavailable from Dell, and this ultimately necessitates some type of relationship with a direct marketer.

The direct market category, which includes MALL, is comprised of companies without retail locations that sell directly to businesses via the telephone and the Internet. Many of these businesses started as catalog retailers in the 1980s and morphed into fairly similar Internet retail models over time. These companies have the advantage of not having to invest in store build-outs and maintain retail locations and distribution facilities. They also can sell on a national (and potentially international). MALL’s largest competitor in this area is CDW (CDWC). Other public competitors are PC Mall (PCCC) and Insight(NSIT). There are also many small private companies that focus on specific products (ex.,discountlaptops.com) operating on a much smaller scale in this category. Combined sales of these public companies in 2004 totaled only about $11bn or about 5% of the total market. Thus, regardless of market size, the direct marketers as a group can grow sales significantly in the near-term purely by capturing market share from other categories—VAR’s in particular.

Business Mix
MALL sells to three types of customers: consumers (about 25% of sales per management), government, and small businesses. PC Mall Gov was formed in April 2002 to target federal, state, and local governmental department agencies as well as educational institutions. Sales in this segment increased 17% in FY04 and a cumulative 29% over 2002, though gross margins tend to be the lowest in this segment. MALL is particularly focused on SMBs and providing them with networking, server, storage, and software licensing. This is because SMBs tend to be repeat buyers, make larger purchases than consumers, and are most likely to form an ongoing relationship with a, informed sales executive that will yield growing sales levels over time. The Company creates customized extranets for these customers that allow them to order online. As previously mentioned, the Company continues to be successful in growing sales to this segment.

Suppliers
The Company has historically been one of Apple’s largest direct marketers and currently accounts for approximately 40% of Apple’s sales through this channel. Apple products comprise about 20% of MALL’s sales and include both consumer items (ex., ipods) but also hardware and software used by creative people at SMB’s (examples include powerful desktop machines and software for graphic design in marketing and advertising on the web, in print, etc). Management views it strong position with Apple products as an effective means of initiating a sales relationship with an IT buyer at an SMB which can then lead to sales of its PC related products and services. MALL other main suppliers are HP, Microsoft, Sony, and IBM.

Competitive Advantage
MALL is in an extremely competitive industry as reflected by intense pricing pressure and tight gross margins. Its customers comparison shop among other direct marketers, retailers, and manufacturers that sell directly. MALL sees its advantages as: (1) low price, (2) large selection (3) rapid delivery (its distribution facility is located within miles of the Fedex hub in Tennessee), and (4) account executive expertise. While some of these advantages leave MALL well positioned vs. other sellers in the IT category, most of MALL’s larger direct marketer competitors (see below) operate very similar businesses and benefit from the same advantages-- in fact the scale of CDWC probably allows it to negotiate better wholesale prices and therefore offer better prices (gross margin is best). Thus, MALL’s success in growing sales over the next several years will probably be driven by the success of the direct marketers as a group in capturing market share instead of MALL’s particular advantages as a direct marketer. Normally, this would not be a particularly attractive situation, but given the size of the IT market, the inherent advantages of direct marketing model in a world where IT buyers increasing turn to the Internet, and the fact that the four largest companies in the space had combined FY04 sales of only about $10bn, MALL still seems compelling.

Further, MALL does benefit from some customer captivity in that once an account executive at MALL has a relationship with a customer, he/she becomes very familiar with that customer’s IT configurations and needs and tracks them via CRM software. This makes it relatively painless and convenient for the customer to come back to the account executive in the future. Over time, this gives MALL some room to expand gross margins and cross-sell new products and services without investing in new customer acquisition.

Financial Summary
MALL has provided results for its business segments down to the operating income level, so a proforma Income Statement and cash flows for the core business can be approximated through FY04 as follows:

Proforma Core Business Results
$(mm) FY02 FY03 FY04 1Q04 1Q05
Net Sales (1) 774.6 865.5 977.6 239.8 236.9
Gross Profit (1) 85.2 114.7 126.2 31.2 26.7
% 11.0 13.3 12.9 13.0 11.3
Operating Income (1) 3.8 6.4 7.0 1.2 (3.3)
% 0.49 0.73 0.73 0.50 -1.4
EBITDA (2) 8.2 10.5 11.4 N/A N/A
Interest expense (3) 0.98 1.32 1.98 0.40 0.66
Taxes @ 38% 1.07 1.92 1.94 0.31 (1.50)
Net Income 1.8 3.1 3.1 0.5 (2.5)
EPS 0.14 0.27 0.26 0.04 (0.21)
Shs Out (FD) 12.1 11.6 12.1 12.0 11.6
Free cash flow 2.3 2.5 4.0 N/A N/A
(1)Per segment break-outs in annual reports, 1Q04 & 1Q05 per 5/10/05 8k filing
(2)Depreciation for the entire business is applied
(3)Interest expense for the entire business is applied, except for 1Q04 and 1Q05 “core business” figures provided in 5/10/05 8k and assumed to be actual
(4)Depreciation and Cap ex for entire business applied, change in W/C not included

Key Points:
Sales: As previously mentioned, sales in the core business have grown steadily through 1Q05 (see below), and given the market size, share dynamics, MALL’s relatively unseasoned salesforce, and management’s total focus on the core business post-spin, it is reasonable to assume MALL can continue to grow sales in the 10%+ range.
Gross Margin: Gross margin for the core business has held steady in the 13% range over the last two years but dipped to 11.3% in 1Q05 (see below)
Operating Income Margin: Management is targeting 2% margin ASAP, vs. 0.7% in FY04. They plan to get there via expense cuts and restoration of gross margin. See Operating Leverage.
Free Cash Flow: MALL delivered about $4m in free cash in FY04, which at the current market cap implies a FCF yield of about 7%. Given the fact that the business is not cap ex intensive, if the company can sales growth back on track and deliver on its operating income margin it is in a good position to churn out cash.

1Q05
Mall sales (excluding ECST) were down about 1% Q/Q in 1Q05, which combined with operating expenses of about $30mm (flat Q/Q) led to an operating loss of about $3.3mm. Clearly, investors are concerned that sales growth has hit a wall, and the stock traded down significantly upon the announcement of the results. Management noted that “the surge in sales that we expected at the end of the quarter failed to materialize despite aggressive pricing promotions intended to stimulate demand.” Total sales performance was comprised of a 13% decline in consumer sales, a 7% decline in government sales, and SMB sales growth of about 8%. Management stated in a recent meeting that it views its promotional efforts in the quarter aimed at the consumer part of the business to have been a miscalculation and it will not repeat them. It blames these efforts for the unusually low gross margin (11.3% in 1Q05 vs. 13.0% in 1Q04).

Thus, while overall performance was disappointing, the good news is that the SMB market which is the Company’s largest and most valuable customer base (see Business Mix above) is still growing nicely, and the gross margin slip can be rectified by better managing promotional efforts in the consumer business. The Company also recently consolidated all consumer sales and marketing operations under Rob Rich, a new hire who prior to joining MALL ran Dell’s Dimension business. Hopefully this will help to stabilize or grow the consumer business.

Liquidity
MALL has a $75mm line of credit with a large commercial bank and has drawn down approximately $49mm as of 1Q05. A 10Q for 1Q05 has not yet been filed so the exact amount of cash the Company burned during this period is unknown, but the loss before income taxes of about $4.0 is probably a good estimate. Thus, the Company could turn to the credit line to fund at least several more disappointing quarters and/or invest in inventory if sales trend up in a meaningful way.

Potential Operating Leverage
The key to MALL’s success going forward will be its ability to exploit the inherent operating leverage in the direct marketing business model. MALL’s public competitors operate very similar businesses, and it seems that as these companies break through the $1bn + in sales they achieve improving operating margins. Note that CDWC is also able to negotiate better prices on products because of its high sales levels, and this has further enhanced its operating margin via a superior gross margin.

Comparable Operating Data – FY04
$(000’s) CDWC NSIT PCCC MALL
Sales 5,737 3,082 1,353 977.6
Y/Y Sales Growth (%) 23.01(1) 6.81 3.12 13.10
Gross Margin (%) 15.2 12.0 11.2 12.9
Operating Income Margin (%) 5.2 2.8 1.0 0.7
Sales Headcount (2) 1,985 1,109 597 706
Rep Productivity (2) 2,972 2,318 2,170 1,273
(1)Much of this sales growth came from the acquisition of Micro Warehouse
(2)As of May, 2005

MALL has three ways of achieving this operating leverage:
*Grow Sales: As the comps above show, MALL’s competitors are able to achieve significantly better productivity from their account managers, and this productivity seems positively correlated to seasoning based on MALL’s own saleforce data:

MALL Sales Force Seasoning
Tenure % of Account Managers Sales Productivity ($mm)
In training 10 0
< 1 year 44 0.6
1- 2 years 17 1.1
2 years + 29 1.9

As MALL reps move into a sweet spot in terms of seasoning over the next 4+ quarters, sales could ramp significantly.
*Expense Cuts: Management believes it can achieve a 2% EBIT margin based purely on “low hanging fruit” variable expense cuts. It says it is finished with SOX spending and salesforce expansion via personnel and infrastructure spending. Assuming increasing the EBIT margin by 1.3% comes purely from SG&A, this means SG&A cuts of about $12.7mm per year. It is difficult to gauge how realistic this is without more information. Most likely, EBIT margin expansion would come via some combination of modest sales growth, expense cuts, and restoration of historical gross margin levels
*Restoring Gross Margin: Management says 1Q05 was an aberration. It tried to stimulate the consume part of the business by getting very promotional on pricing and the sales increase it hoped for from this initiative never materiliazed. It seems reasonable to assume MALL can return the gross margin to prior levels.

Valuation
Net Asset Value
MALL currently has a tangible book value of about $50mm or $4.54 per share ( based on MALL proforma B/S provided by company in 4/15/05 8k filing). Assets are comprised mostly of A/R ($92.4mm) and Inventory ($78.9mm) with cash of approx. $6.5mm, and the main liability is about $52mm in debt comprised of a LOC drawdown and a $2mm note payable. In terms of reproduction value, MALL has several valuable assets that are not carried on the B/S but that would have to be replicated to compete effectively with MALL, as follows:
*Customer Lists: A direct marketer’s active customer list (repeat customers who have bought within the last 12 months) is extremely valuable. MALL calculates that it spends $150+ in marketing to acquire each active customer. MALL does not publish the number of active customers it has, but management has indicated it is “a little less than 1 million.” Further, the company has indicated that its average sale is about $800, and with $997mm in sales, this implies about 1.2mm customers. But at even 500k active customers @ $100 each, this represents a $50mm asset, or $4.31 per share not reflected on the B/S. Management also alluded to a sale of a customer list of an online IT seller to Office Depot. This acquired company had only $120mm in sales, and its customer list was sold for about $50mm—this comp is in the process of being verified.
*Brand: Identifying the value range for a brand is a complicated and time-consuming task, but a back-of-the-envelope approach is to add up advertising historical ad expenditures over some period of time. MALL spent about $40mm, or $3.45mm per share on advertising over the last two years.
*Sales and distribution infrastructure: MALL has an strong sales platform that includes a new telemarketing facility in Canada with 270 sales reps and capacity for 125 more, training systems, customized CRM software, and extensive MIS. While its main public comps have similar systems, the fact is that MALL has invested heavily in these assets over the past several years and any new competitor would probably have to spend significantly more than the $9mm of net PP&E on MALL’s balance sheet to reproduce them and compete with MALL.

In sum, MALL’s net asset value, which on a conservative basis is probably $7.00 - $9.00 per share, defines a reasonable downside valuation for the Company.

Comp Trading Multiples
MALL is currently trading at about 9.0x its proforma FY04 EBITDA which seems to be in-line or somewhat high given its public comps below:

Last 12 Quarters (6/30/02 thru 3/31/05)
Revenue Multiple P/BV TEV/EBITDA Current (5/24/05)
High Low Average High Low Average High Low Average TEV/Rev. P/BV TEV/EBITDA
CDWC 1.05x .71x .87x 4.96x 3.57x 4.34x 14.10x 9.68x 12.19x .71x 3.90x 9.53x
NSIT .55x .11x .27x 2.65x .85x 1.61x 13.86x 3.82x 7.27x .25x 1.54x 6.88x
PCCC .22x .13x .15x 1.79x .85x 1.05x 15.95x 7.37x 9.52x .27x .85x 5.79x

But MALL’s P/BV (1.04x) and Sales multiple (0.10x) seem low compared to the comps, especially since it has been growing sales more quickly than PCC and NSIT and at about the same rate as CDWC (organic sales). It is also worth noting that the entire comp set is trading at relatively low multiples compared to historical levels over the last twelve quarters. This is probably due to general cynicism in the market regarding if/when overall IT spending will come out of the doldrums it has been in for the last 3-4 years.

Forward Multiples (see base case and upside case below)
As the Proforma Core Business Results table shows, despite stumbling in 1Q05, MALL has consistently grown revenue and operating income in its core business over the last three years. As a Base Case scenario, assume the Company’s sales are flat or grow modestly Y/Y in FY05 but the Company is able to reach say a 1.5% operating income margin through expense cuts and gross margin reversion. This would mean EBITDA of about $19mm (EBIT of $15mm plus depreciation of approx. $4mm). As the table above shows, MALL’s competitors (CDWC is the only one with greater sales growth thru FY04) have EBITDA multiples that center around 7-8x. It would not be unreasonable for the EBITDA multiples to move back into the 10x – 12x range at some point when IT spending is perceived to be on the mend and tech companies come back into favor. Nonetheless, an EBITDA multiple of 7.5x would imply an equity value of about $103mm or $8.38 per share. An Upside Scenario would be MALL growing sales by say 10% in FY06 and delivering an EBIT margin of 2% for EBITDA of about $27mm. Assuming some debt expansion ($10mm) to fund inventory due to sales growth, a 7.5x EBITDA multiple implies an equity value of about $12.80 per share.. MALL has traded at EBITDA multiples as high as 19x and its comps have traded in the 13-14x range within the last 12 quarters (see above), so if sales growth gets back on track for MALL and its competitors, MALL could be rewarded with significant multiple expansion by growth and momentum investors that would push the stock substantially past the $12.80 per share level.

In terms of a P/E multiple, applying interest expense and taxes at 38% to both of the scenarios above yields EPS of $.66 and $1.09 respectively. CDWC and PCCC currently trade at P/Es of about 16-19x. Assuming a P/E multiple of 15x for MALL under the Base Case and Upside Case scenarios yields a stock price of $9.90 - $16.35.

Further, it is entirely possible that MALL could achieve EBIT margins in excess of 2% over the next several years. CDWC, which is a very similar business but on a larger scale, had a FY04 gross margin of 15% (volume discounts) and EBIT margin of 5% (operating leverage on $5mm in sales). Clearly, there is a lot of upside in the stock price if MALL can execute.

Forward Earnings Scenarios
$(mm) Base Case Upside Case
Sales 997.0 1,098.0
Growth % 0% 10%
Operating income 15.0 23.0
Margin % 1.5 2.0
EBITDA 19.0 27.0
Interest expense 2.6 3.0
Taxes @ 38% 4.7 7.6
Net Income 7.7 12.4
Per Share .66

*HP: Hewlett-Packard has a new CEO and its business model may be in flux. Since MALL sells quite a bit of HP, if the Company changes its business model (ex., decides to sell direct like DELL) this could have a negative impact on MALL

Catalyst

*Gross margin reverts to normal level and expense cuts cause EBIT margin expansion and potential multiple expansion, even w/out sales growth.
*Sales force seasoning and/or improving IT market spurs sales growth and operating leverage, potential multiple expansion as growth and momentum investors gets interested again
*Sale to competitor down the road (MALL would be accretive to CDWC and easy to integrate, and management has stated it will “consider all options to maximize shareholder value”).