Description

Tech Data (TECD) is the #2 world wide distribution and logistics services provider for information technology (IT) products, with FY01 (1/31/01) sales of 20.4 billion. The difficult distribution industry environment of the last few years ended up demonstrating that TECD and #1 Ingram Micro (IM) are toll gate businesses with large barriers to entry, significant pricing power, manageable working capital, and variable cost structure. Recent declines in demand for IT products presents a TECD buying opportunity for focused-value investors who want to participate in the growth of world wide demand for IT products without having to guess which companies will survive competition or which technologies will lead to viable business models. When the current cyclical downturn ends, TECD’s stock price is likely to at least double as sales growth, profit margins, and the P/E multiple return to normal levels. Factoring out cyclical swings, double digit growth rates of TECD sales and EPS for many years to come is likely due to growing world wide demand for technology, growth of distribution outsourcing, and opportunities for further consolidation abroad. While similar arguments can be made for IM (whose lower profit margins offer greater recovery potential and lower valuation limits the downside), TECD’s consistently lower SG&A, better (ABC) cost accounting, and superior management have been competitive advantages enabling them to steadily win market share from IM while at the same time enjoying higher net profits.

A glance at the last few years’ financials without understanding the industry environment might lead one to believe TECD is a mediocre business undergoing a risky sales expansion – substantial debt with rising debt/equity ratio; low and declining gross margins, profit margins, and ROIC; a 2001 EPS about the same as that of 1998. The following industry discussion provides context for why TECD’s financial position deteriorated during the past 3 years and is likely to recover within a year or two.

The Industry:

Beginning in 1998, several smaller distributors challenged IM and TECD with lower prices in order to gain market share. The brutal 2 year price war which followed resulted in bankruptcy, consolidation, or voluntary withdrawal of every large broadline U.S. distributor except IM and TECD. Shortly thereafter, in the Spring of 2000, IM began raising prices and TECD used this as an opportunity to gain market share among some vendors and customers, while raising prices to others. However, the subsequent cyclical downturn in corporate IT spending combined with a weak economy and continued Euro currency declines have obscured the much strengthened competitive positions of TECD and IM due to declining 2001 sales at both companies. The sales decline is due to falling demand and falling prices for IT products (pricing is Cost Plus negotiated specifically for each vendor – vendor price is marked up by a fixed percentage, so falling vendor prices hurts just as much as falling demand), and it is difficult to predict when growth in IT spending will resume.

During the industry shakeout, TECD grew market share faster than IM principally because lower SG&A enabled them to simultaneously offer better pricing while maintaining higher margins. While this difficult period hurt both TECD and IM’s financial results, it actually had long run benefits of eliminating direct U.S. competition, allowing for market share gains, and dissuading future entrants into the industry by demonstrated the high the barriers to entry and cost of failure.

TECD and IM now have “toll-gate” characteristics in the U.S. as follows:

· The large number and diversity of resellers make it cost efficient for vendors to rely on broadline wholesale distributors to serve this customer base. IM and TECD are the only 2 distributors who adequately serve the U.S. market, and are the best 2 for global distribution.
· Small to mid-size vendors must use TECD/IM to supply large segments of the U.S. market. Even large companies which could ship direct use TECD/IM for most shipping in order to take advantage of their expertise, reduce costs, and focus on core competencies. TECD’s (and IM’s) economies of scale allow for efficiencies of warehousing, transportation, B2B E-commerce, and build-to order operations which are costly and time consuming to build from scratch.
· Large barriers to entry – to compete with IM or TECD, a new entrant would need expertise, capital, a large network of warehouses, and finely tuned systems enabling E-commerce, build-to-order operations, technical support and other capabilities. Such an entrant would need to sustain losses for many years until the vendor/customer base was large enough to leverage the large initial overhead. The failure of all U.S. challengers to IM and TECD during the last few years demonstrates the high barriers to entry. I believe barriers are higher for IM and TECD than distributors in other industries due to larger scale, larger number of value added services, and more demanding systems requirements.
· Toll-gate status was demonstrated in TECD/IM price increases which occurred over the past 12 months – these prices are sticking in spite of declining IT spending.

TECD and IM are NOT pure toll-gates, due to the following:

· The possibility that large vendors can self-distribute constrains pricing. In FY01 ending 1/31/01, CPQ and HP respectively accounted for 20% and 19% of TECD sales.
· Existing self-distributing direct sale firms such as Dell and Gateway constrain pricing – these companies can gain market share from TECD vendors if TECD prices too high.
· Niche distributors may better serve certain market niches due to superior expertise or customer/vendor relationships.
· Software may be increasingly distributed electronically in the future, possibly bypassing TECD/IM.
· Outside the U.S., distribution is highly fragmented, though there are beginning signs TECD and IM (the 2 distributors with the highest sales in Europe) may be able to consolidate distribution in Europe over the next few years. Japan’s dominant distributor Softbank is a company large enough to potentially present a global challenge to IM or TECD, but this is unlikely to happen soon as they are suffering from money losing dot com VC investments.
· TECD competes with IM, a formidable competitor whose SG&A is coming down fast. During the last few years, TECD has consistently outperformed IM, but IM can take advantage of any mistakes they make in the future or potentially initiate a price war. Note that TECD has benefited from recent IM missteps, such as IM replacing phone support with web support for resellers. Note also that neither TECD nor IM has initiated price wars in the past and both claim they were forced to respond to irrational pricing during 1998 or 1999 to fend off competition. Nevertheless, pricing is constrained by IM, and TECD mistakes can and will happen.

The Numbers:

· For the last 10 years (led by current CEO), TECD’s per share sales, cash flow, earnings, book value and share price have grown at an annualized rate in excess of 25%. TECD is unlikely to grow so fast going forward as the easy U.S. market share gains are in the past, though there is still plenty of room for international growth. International represented 45% of FY01 sales.
· TECD currently has 9% of world wide distribution outsourcing market share (IM has over 13%), with trailing sales of 20.4 billion in FY01 (ended 1/31/01). International Data Corp. projects that the microcomputer distributions industry’s share of the overall IT marketplace will grow from 27% in 1998 to 33% in 2004, thus growing TECD’s potential market faster than growth in IT spending.
· Near term, company guidance for Q2 ending 7/31/01 is for 4.1b to 4.3b sales, .39 to .45EPS, which is a drop of nearly 20% in sales from last year’s Q2 and drop of around 40% from last year’s Q2 EPS. Q1 also had year over year declines. It is this near term cyclical downswing which has caused the stock price to drop over the past year. Note that 5% of the staff has been let go during Q1, mostly through gradual attrition.
· Tangible Book value of $16 provides downside protection as most tangible assets are inventory and A/R. TECD inventory is substantially protected from product obsolescence and price cuts by various agreements with vendors (see p.3 of 10-K). TECD’s customer base is highly fragmented so problem credit with any single customer has a small impact on bad debt write-offs. Also, TECD has credit insurance on a portion of it’s A/R. The shakiest part of book value is the assets in Europe, which have been rapidly eroding due to the decline of the Euro currency vs. the dollar (see 26 of 10-K – accumulated other comprehensive loss in last 2 years is due entirely to declining Euro). Given the relatively high quality of assets and the fact that TECD in unlikely to suffer a loss (due to cost plus pricing and its competitive position), TECD’s stock price is unlikely to drop much below $16.
· For most of the past decade, TECD’s stock price has traded within a few points of 12x cash flow (net income + noncash charges - if you have value line, look at TECD graph). Based on value line’s projection of this year’s $3.80/share cash flow (which optimistically assumes a second half recovery in global IT spending), 45 is the 12x (FY02 estimated) cash flow price.
· Though growing in the long term, IT spending is also cyclical, and so is TECD. Cyclical companies should not be based on cash flow or EPS near the bottom of the cycle. It is more rational to value cyclical companies based on normalized earnings. Following is an attempt to get at normalized, sustainable earnings a few years out to get at future value (Purposely ignoring the negative short term trends which will continue for the next 2-6 quarters).
· During the past decade, TECD’s net profits have fluctuated between 2.0% and 0.7%. While latest quarterly net profits were 0.7% and are likely to stay below 1.0% in FY02 (ending 1/31/02), they are likely to revert to the mean of 1.4% or so when IT spending resumes growth, given recent price increases by TECD and IM, workforce attrition, the rollout of TECD’s ABC system outside the U.S., and efficiency gains from ongoing IT systems enhancements.
· P/E has fluctuated between 10 and 23 over the past 10 years, averaging around 15.
· Assume (Pessimistically) IT spending resumes 1.5 years from now, and TECD’s FY04 (ending 1/31/04) sales recover to FY01 revenue level of 20.4 billion, while net margins return to 1.4%, fully diluted share count grows to 66m, and P/E rises to 15: TECD’s stock price at the end of 2003 would then be 64.95 (15 X 4.33EPS), with double digit growth going forward after the recovery. Discounting at an annualized rate of 15% produces a current expected stock price of around $47/share.
· The above assumptions are certainly open to question, given the unpredictability of IT spending and therefore revenue. The duration & severity of the IT spending downturn has a big impact on how long it takes for TECD sales, income, and stock price to recover.
· TECD’s 1/31/01 debt/equity ratio (including revolving credit loans which are listed as current liabilities but are realistically permanent debt financing) is 1.31– something to watch, particularly if TECD acquires debt-laden distributors. Note that IM has an advantage here with a debt/equity ratio of 0.75 (including IM’s off-balance sheet securitized A/R liability). IM’s stronger balance sheet is largely due to the lucky timing of an investment in and sale of Softbank stock. Near term, IM is more able to pursue acquisitions with its stronger balance sheet.
· Most of TECD’s debt is revolving credit which funds working capital needs. Due to declining sales, working capital requirements declined Q1, and so did revolving debt. Also, interest rates will be falling on this revolving debt in conjunction with the Fed’s interest rate cuts (with a several month lag).


The Opportunities:

ABC system which gives accurate costs per vendor/customer account in U.S. is being rolled out world wide, to be mostly implemented by the end of 2001. This will increase margins in foreign operations (which are lower than domestic margins) over the next 1-2 years.

Recovery of the economy, IT demand, a big hit product (Windows XP?) and/or Euro currency would revive sales and EPS growth. Even if the downturn is prolonged, downside for TECD’s stock price is limited and more consolidation opportunities may come along. In latest CC, management reported increased quoting activity among its corporate reseller customers, which may indicate IT spending is near the bottom of the cycle.

Consolidation in Europe has begun and may intensify over the next few years, with IM and TECD as the consolidators. Prior acquisitions by TECD and IM have been integrated in a timely manner without resulting in negative surprises.

TECD and IM’s global presence makes them preferred partners for many vendors who want to consolidate their distribution, further strengthening their “toll-gate” status. For example, CPQ used to have a large number of distribution partners but a couple years ago reduced that number to 4. TECD and IM both made the short list.

Growing use of the internet spurs demand for IT in general. TECD and IM are the preferred back office and distribution partner for internet retailers of computer related products. TECD ranked 13th in E-commerce sales volume according to Inter@ctive Week’s Interactive 500 listing.

Continued addition of valued added services (too numerous to list here – read pp.1-5 of 10-K) cements vendors/customer reliance on TECD and adds incremental revenues. A particularly interesting example is recently launched SupplyXpert, a storefront application that lets VARs select products from TECD catalog and sell them through their own branded sites. TECD charges ongoing fees of $500 or more per month for each VAR using this service.

Continued market share gains from IM so long as SG&A continues to be lower.


The Threats (See also above section on how TECD and IM are not pure toll gates):

High debt/equity ratio puts TECD at disadvantage to IM in making acquisitions, and increases risk of future acquisitions overwhelming TECD with too much debt.

Direct sellers such as Dell continue to chip away at IM/TECD systems sales and may cause major TECD PC vendors to exit the PC business altogether. However, systems represented only 28% of sales FY01, and only 25% during 1stQ as other higher margin product lines grew. There are only a few large companies capable of profitable direct sales while there are tens of thousands which will never self-distribute. Also, technology is so dynamic that there will always be segments of TECD’s product mix which decline and/or commodify while offset by higher margin and growth emerging technologies. TECD management has demonstrated an amazing ability to navigate these rapid changes better than the competition.

CPQ or HP could decide to self-distribute a much larger percentage of their product. Note that some feared CPQ would do this after purchasing warehouse assets from defunct distributor Inacom last year but TECD’s CPQ business has continued to grow after CPQ’s acquisition.

IM has targeted SG&A as its highest priority this year, and it is falling fast. If it is able to match TECD’s SG&A, then TECD is unlikely to grow faster than IM in the future.

Unpredictable directions of economy, IT spending and foreign currencies – may get worse before getting better, particularly Europe’s economy. Note that TECD has done a great job of reducing inventories, A/Rs, and headcount along with declining sales while maintaining high service levels during the current economic downturn and in general has managed difficult times for the industry better than competitors in the past.

In general, global IT spending is erratic, which makes for unpredictable near term fluctuations in quarterly revenue and produces lumpy results. This doesn’t matter in the long run but in the short run can be disconcerting to investors, increasing stock price volatility.

TECD has a considerable number of options outstanding, though most are currently out of the money. If they decide to re-price the options, as have a number of other technology related companies, this would destroy much shareholder value.

TECD’s low margin, high debt, high asset turnover business model leaves little room for error, as recently-bankrupt competitors demonstrated. SG&A rising by a mere ½ % of sales or Gross Margins falling by ½ % of sales would have a devastating impact on TECD’s margins and competitive position.

I consider the biggest threat to be mismanagement of the European operations, which represented 38.2% of FY01 sales. The ROIC in Europe has been declining for several quarters due to falling margins, ballooning inventory, and ballooning A/R. TECD provides geographic segment detail in 10-Ks and 10-Qs which break out sales, operating income, and identifiable assets for each region. This threat is also the biggest opportunity – if their ABC system rollout in Europe has a similar impact to its effect on U.S. operations, this will be a big lift to EPS and ROIC.

While the above list of threats may seem daunting, most of these threats have been present for the last decade during which management did a phenomenal job of navigating competitive pressures, rapidly changing product mixes, and unpredictable IT spending cycles. The result has been 25% annualized returns for TECD investors during that time period.

Catalyst

Rollout of ABC system to Europe

Recovery of the economy, IT demand, a big hit product (Windows XP?) and/or Euro currency would revive sales and EPS growth.

Consolidation opportunies, particularly in Europe.

Continued market share gains from IM so long as SG&A continues to be lower.