Description

Pomeroy is trading at an extraordinary valuation: 2.1x EV/EBIT, 60% Tangible book, and EV/EPS 2.8x, for one very good business and one less attractive business. Pomeroy is a VAR (50% of GP, $525-545mm, 1.9% OM) and IT (50% of GP, $130-140mm, 12% OM) services company, with a 20 year history of profitable operations (from 1996-2002 company netted $9.19 or 153% of current EV, AFTER deducting vendor receivable write off’s). PMRY is trading at what I consider to be a fantastic risk/reward opportunity ($6 downside/$14-15 upside). From Jan 1996 to Jan 2003, PMRY has grown Tangible book value by 637% from $19.40mm to $143mm while retained earnings have grown from 1,965% from $6.1mm to $126mm. The company primary ability to generate strong operating results over time comes from: a) Dominant in small markets (pricing discounts from suppliers, which allows PMRY to buy competitors at very attractive multiples 3-6x EBIT) b) a Wal-Mart type strategy, highly disciplined on cost side of their business c) multiyear contracts with fortune 500 company’s (E.g. Proctor and Gamble 3 yr $40mm contract). In addition, PMRY has a very strong balance sheet, ($3.35 per share, including tax refunded expected early March 2003) about 2x Cash, plus debt free, with Bank lines of $240mm (5.3x EV and 2.67x Mt cap).

Pomeroy guided for 2003 of $1.22-1.26 EPS (made very small acq. EPS estimates are now @ $1.30 from Rodman analyst, this assumes no buyback as well) this year on $660-680mm in revs. The key point is yes, it is a low multiple business, however PMRY is trying to transform into a higher margin/multiple company by driving 67% of GP via IT services over the next 18 months. CDW (CDWC) yesterday stated “conference call (39.80 -2.98) Listening to conference call, about the only thing we hear that might spook investors is company's mention of being open to acquisitions, when CDWC has never done an acquisition before. Co responds that acquisition would have to be very value-oriented if they were to do a deal...” I think CDWC maybe look to acquire PMRY considering valuation and strategy of being strong in second tier markets. Bottom line:I think PMRY is worth at 7x $1.30EPS= $9.10 + cash $3.35= $12.45 (or +81%).


Let me jump in and explain the issues surrounding the company and seek to explain why I think the stock is substantially undervalued:

Why the stock is cheap:
a) Difficult industry: Basically many competitors went out of business in the mid 1990’s, because margins were/are thin on VAR side, and competed with undifferientatied strategies in competitive markets.

PMRY strategy is to compete in less competitive markets (second tier or Non-NFL cities) with higher margin IT services, and strong cost focus has led to 20 years of profitable operations, (7 as a public company). So PMRY differientiated strategy has been successful vs. competitors.

b) Vendor receivable write offs (I believe this issue is resolved now)
Vendor receivables

Gross Net DVRO1 DVRO2
Oct ’01 38.53 37.426 16.5 22.1
Dec ’01 40.33 24.219 10.7 14.2
Mar ’02 34.77 18.666 9.0 12.0
June ’02 33.79 17.267 7.9 10.4
Oct ’02 28.83 12.720 6.7 9.1
Dec ’02 29.74 10.29 6.2 8.5


a) Both numbers show significant improvement in collections (6-8x is the industry average, which is where they are now)

b) Days VR Outstanding 1=(Net VR *90)/sales
Days VR Outstanding 2= (Net VR*90)/Cost of sales (VAR only)
c) 95% of vendor receivables are within 45 days (conf. Call on Feb 13, 2003)

d) Not an industry wide problem according to CDWC/CMPC and other industry competitors.
e) Company has changed practices to focus on weekly vs. monthly collections, and have had no problem collecting VR’s over the last 18 months.
f) PMRY believes that they could get some benefit out of VR’s that have been written off, potentially greatly discounted rate or some other benefit, I personally doubt this will happen.
g) What happened: PMRY grew its business from $100mm to nearly $1bn from 1995 to 2000. The company got sloppy on following the required procedures to collect the VR’s. Failed to write them off, in a timely manner (this has clearly crushed the stock). Caused write off in 2002 and 2003 of $15.93mm and $2.067mm.

h) Family operators (PMRY’s own approximately 16% of the shares outstanding), Steve and Dave Pomeroy have been great at buying competitors at very favorable prices and not buying anything over the last 18 months. Except just made 1st acquisition last week buying Micrologic, which should add .03-.05 to this yrs eps or about $1.30.

d) Bad news hit stock in Jan + geo-political fears + small cap with limited following dropped –46% from $12.98 to $6.99, since Jan 2003.

e) Short interest covering:
Mar 2002: 326,000
Jun 2002: 272,000
Sept 2002: 250,000
Dec 2002: 127,000
Jan 15, 2003: 110,000
Feb 15, 2003 95,000
Out of 12,800,000 shares






Businesses
2002 VAR 9months
Per share ebitda= .92
Per share FCF= .60
2002 IT Services 9months
Per Share EBITDA= .99
Per share FCF= .82

PMRY Combined VAR and IT services:

2002 actual
EBITDA: $2.18 per share
EBIT: $1.73 per share
FCF: $1.54 per share

EV= $3.65 per share
EV/EBITDA= 1.7x
EV/EBIT= 2.11x
Ev/FCF= 2.37x

2003 Estimate (stabilizing business + cost cutting, NO acquisitions on buyback included)
EBITDA $2.42 per share
EBIT $1.92 per share

EV/EBITDA= 1.5x
EV/EBIT= 1.90x

Yr Revs Net
1996 $230 $0.73
1997 $336 $0.77
1998 $491 $1.44
1999 $756 $2.11
2000 $925 $2.37
2001 $809 $0.60 (after VR write off $16mm)
2002 $702 $1.17 (after VR write off $2mm)
2003 $675E $1.30E

B-sheet
Paid off all debt last 12 months
Cash $43mm as of Mid March ($34mm + $8.3mm tax refund coming in March 2003)
sold leasing business last March
Buying back stock have been buying back 1-2% per qtr last couple qtrs $12+ on cost basis
Inventory turns: 9+ per qtr.


Business Value
Give PMRY a -0- value for VAR business (I would suggest that should not be the case a multiple of 2-3x EBITDA would be reasonable). Then you have an EV of $44mm for an IT services company that will generate nearly $12mm in FCF, an incredibly strong financial backing to buy out distressed competitors in this market ($240mm), and well designed strategy ($9.19 in EPS from 1996-2002).

Potential hedge is shorting CDWC ($4bn mkt cap) @ 11x CF and long pmry @ about 2x if you do not like the industry.

I made a mistake on this stock about 13 months ago in writing it up, but i believe now it is a ridculously cheap stock and should offer investors substantial risk adjusted returns.

Catalyst

1) I think CDWC could be setting up to try to buy PMRY, given yesterday’s news and CDWC size, strategy, impact to their business, and huge cash balance.
From Briefing.com: RE: CDWC “(39.80 -2.98) Listening to conference call, about the only thing we hear that might spook investors is company's mention of being open to acquisitions, when CDWC has never done an acquisition before. Co responds that acquisition would have to be very value-oriented if they were to do a deal”


2) PMRY has been buying back 1-2% per qtr last 2 qtrs over $12 per share, I expect a $5mm+ stock buyback soon (discussed on CC, that would add about $.10 to EPS on if they bought back 1mm shares @ cost of $8 per share).
3) Substantial downside protection: safety net 60% Tangible book, 2x Cash, $1.30 in EPS (on depressed yr), strong CF, likely buyback, potential acquirer target or PMRY could buy distressed competitor with very strong b-sheet.
4) Company from 1996-2002 Earned $9.19 per share Net in 4 years (AFTER backing out all VR’s write-off’s) vs. $7 stk price or trading for about 75% of EPS over that time period.

5) I think PMRY would be a good acquisition candidate for CDWC.
CDWC trades @ approximately 10x EV/CF vs. PMRY 1.9x EV/CF (plus investors who do not like industry can short CDWC and buy pmry to hedge risk)