Wayside Technology Group (“WSTG”), formerly known as Programmers Paradise, has a market cap of about $40 million and $23 million of net cash on its latest balance sheet (6/30/08) for an enterprise value of $17 million. WSTG’s enterprise value is currently about 8% of LTM revenues, 2.8x LTM EBITDA, 3.5x LTM EBIT, 4x LTM free cash flow,  and 5x LTM EPS.  ROIC is well over 100% as working capital and cap ex needs are small.  The annual dividend is currently 60 cents or 7.5% dividend yield.  We think WSTG is a reasonable business trading at a relatively cheap price.  Interested readers should take a look at WSTG’s cash flow statements (below), which show an impressive ability to consistently generate cash over the last five years (2003-7).  The company paid dividends of $1.5 million in 2003, $1.7 million in 2004, $2.0 million in 2005, $2.4 million in 2006, and $2.7 million in 2007 (and also bought back close to $1 million of stock in 2007).

WSTG markets technical software to software development and IT professionals in the U.S. and Canada.   It operates in two segments:  Programmers Paradise (PP) and Lifeboat (LB).  Programmers Paradise segment sells technical software (mostly), hardware (very small amount), and services for microcomputers, servers, and networks to individual programmers, corporations, government agencies, and educational institutions, including solutions from various publishers and manufacturers.  Programmers Paradise markets products through catalogs, direct mail programs, and advertisements in trade magazines, as well as through internet and email promotions.  Lifeboat segment distributes technical software to corporate resellers, value added resellers, consultants, and systems integrators.  The company offers technology products from software publishers and manufacturers such as Microsoft, CA, IBM, VMware, Borland, Quest Software, Compuware, Infragistics , Component One, Macrovision, and Adobe.  Lifeboat distributes these products to thousands of solution providers, VAR’s, systems integrators, corporate resellers, and consultants worldwide, including CDW (largest customer at 10.5% of sales in 2007), Software Spectrum, Softmart, Insight Enterprises, ASAP Software, CompuCom, Entisys, SHI, etc.  The company basically extends the marketing and distribution capabilities of these smaller software companies to allow them to efficiently reach a network of thousands of VAR’s, systems integrators, etc. which is serviced by WSTG.

 LTM Programmers Paradise revenues are $48 million and gross profit is $5.7 million.  LTM Lifeboat revenues are $130 million and gross profit is $10.8 million.  Gross profit margins are obviously better on Programmers Paradise’s reseller segment versus the Lifeboat distribution segment.  We have included financial results by segment below. 

The company’s goal is to become the most trusted and respected software supplier, not the largest or the cheapest.  Competition is based on service, ease of doing business, price, and knowledge.

The company seeks to grow its business through continued investments in IT and marketing to drive sales; having motivated and trained salespeople by investing in human resources; and tightly managing expenses so that expense control becomes a competitive advantage.

You can look at the company’s website at www.waysidetechnology.com and the websites for its operating subsidiaries at www.programmers.com, www.lifeboatdistribution.com, and www.techxtend.com. 

The company experienced rapid sales growth until 2007 due to distributing fast-growing VMware (ticker: VMW) virtualization software.  The company was VMware’s first distributor.  However, due to strong price competition the gross margins on VMware-related sales declined to levels which were not economic, and the company has refused to chase these ultra-low margin sales.  This focus on profitability over rapid sales growth resulted in slower revenue growth, especially starting in the second half of 2007.  To offset these revenue declines, WSTG has successfully focused on adding additional software vendors and increasing penetration with existing vendors.  During Q1 2008 distribution agreements were signed with 11 new software publishers and non-VMware sales increased 11% versus prior year.  During Q2 2008 agreements with 14 new software publishers were signed and non-VMware related sales increased almost 20%.  Management is correctly focused on growing gross margin dollars and diversifying its revenue base away from low margin VMware distribution business.  Management is also doing an excellent job of tightly managing SG&A expenses, with a strong focus on increasing efficiency by improving revenues and gross profit dollars generated per sales executive.   Gross margin dollars have steadily grown from $8.96 million in 2004 to $17.24 million in 2007 while SG&A expenses have been leveraged to generate strong growth in EBIT, from $0.82 million in 2004 to $5.16 million in 2007.

The steady growth in gross margin dollars over the 2003 to 2007 period, and the company’s success in replacing some of its low margin VMware business with new software vendors at more reasonable gross margins, gives us some confidence that the company’s business model is viable and has a reason to exist.  We believe the key for WSTG will be its ability to add enough value for its vendors and customers to earn a reasonable gross margin while maintaining a stable expense structure.  Management believes there is a strong need for added services in the software distribution channel and that its vendors want and need more than just providing an SKU number and the price.  Management thinks there is a strong need for technical licensing knowledge, training centers, and consultants on the distribution side.  Management maintains its vendors are very supportive of its value added approach and this has been a major factor in adding software lines to its vendor base.

We would be the first to admit that WSTG’s business model is no Ft. Knox as price competition is fierce and the softer economy has some of the company’s larger customers pushing more price pressure down onto their distributors such as WSTG.  Nevertheless, the company’s lean cost structure and asset-light business model have allowed it to compete effectively in this tough environment.  We are impressed with the amount of cash the company has generated over the past five years.  At year end 2003 cash was $11 million and by year end 2007 cash had increased to $24 million, up $13 million.  During this period the company was also able to pay out roughly $11 million of dividends to shareholders.   Consequently, total cash generated during 2003-7 was about $24 million, or close to $5 million per year.   We think this is attractive for a business which is being valued at an enterprise value of $17 million.  It is certainly possible that annual cash generation may decline in the future but investors are not paying a lot for this business.

One major headwind for the company over the past 12 months has been it position as a major distributor for VMware’s successful virtualization software.  VMware represented 35% of total vendor purchases in 2005 and 53% in 2006 before declining to 36% in 2007 and 29% for 6 months 2008.  VMware’s rapid growth resulted in strong revenue growth for the company which drove its stock price up significantly, reaching the high teens in mid 2007.  However, the company’s stock declined during the second half of 2007 as gross margins on VMware business became uneconomical, sometimes close to a 1% or even 0% gross margin, due to new volume-oriented distributors for the VMware product.  As a result of the company’s decision not to chase sales at the expense of gross margins, the company’s sales of VMware products declined during H2 of 2007 and H1 of 2008.  Despite declining VMware sales and VMware gross profit dollars over this period, the company has been able to keep total gross profits relatively steady as low margin VMware business has been replaced by business with new software vendors or increased penetration with existing software vendors at more reasonable gross margins.  We are keenly focused on gross margin dollar trends here and the company was able to keep gross margin dollars flat versus prior year in Q2 despite a large decline in VMware-related sales.  Non VMware sales have consistently grown over the last several quarters, increasing $5.4 million or 20% in Q4 2007, $2.9 million or 11% in Q1 2008, and $4.0 million or 21% in Q2 2008.  This provides some evidence that management’s strategic plan to become a more diverse value added distributor is starting to work.  We believe the company’s strategy of diversifying its vendor base will continue to be reasonably successful over time, although it may not happen in a straight line.

Importantly, while VMware represented a large portion of the company’s sales, its contribution to the company’s gross profit is much less due to its low margins:  for 6 months 2008 VMware only contributed about 8% of total gross profits while contributing 29% of total sales.  The company added 11 new software vendors in Q1 and added 14 new software vendors in Q2.  We think these actions help reduce the risk in the company’s business model and allow its sales people to focus on higher margin software opportunities where more value is being added and where the company is being better paid for its efforts.

The company discussed the VMware situation on the Q2 conference call:

“Total VMware labeled distribution sales in the first six months amounted to $20.9 million or 24% of our total net sales.  Most important however to us is gross margin.  Product margin for VMware labeled distribution sales for the first six months amounted to $640,000 which is 8% of our total gross margin.

As discussed in our previous conference calls, VMware started to significantly change its distribution model in 2007.  New VMware distributors adopted ultra low pricing strategies.  This resulted in reduced sales and gross margins for our company.  Now even more volume distributors have been authorized by VMware.  It is therefore that both companies believe that at this point focusing on our relationship on Programmers Paradise and TechXtend is mutually beneficial.

We have the commitment from VMware’s management to work much closer together on the reseller side.  We will also continue to sign on new software vendors on the distribution side.  We do not foresee immediate cost savings as a result of this termination.  As a result of these factors, we cannot currently estimate the financial impact this change will have on our company.  We still have a full quarter ahead of us in terms of VMware distribution and we’ll update you next quarter.”

We just want to make clear to VIC readers there is some uncertainty in the financial impact of the future VMware relationship.  However, we believe VMware’s contribution to total gross margin dollars has become sufficiently small that we do not think this relationship change will have a large impact on profitability.  We also think company management is right to focus on growing gross margin dollars and making sure they are adequately compensated for their services rather than chasing no margin sales deals.

Declines in VMware sales have been masking what we think is solid growth in Lifeboat’s non VMware distribution business.  In 2007 Lifeboat sales grew 5% to $135.1 million versus $128.6 million prior year, despite a $17.3 million decline in VMware sales compared to 2006.  This growth at Lifeboat was due to new software lines added and increased penetration of existing accounts.  Excluding VMware related sales, Lifeboat sales in 2007 increased by $23.7 million.  Lifeboat sales in Q2 of 2008 were $35.0 million versus $33.7 million prior year, up 4%. 

WSTG’s attractive business model allows the company to earn high returns on invested capital and generate significant free cash flow.   We concede that gross margins and operating margins are thin (not surprising for a distributor) but also note that, nevertheless, the returns on invested capital are very attractive, which is the most important factor to us.  We think WSTG’s most important asset is its relationships with its software vendor partners and it extensive customer base of value added resellers, systems integrators, and other IT professionals.

 

We believe the company can continue to generate $4 million or more of annual free cash flow (over 80 cents per share).  Importantly, this not based on some peak level of results recently achieved but rather reflects less than the average level of cash from operations less capital expenditures achieved for 2005, 2006, and 2007.  This represents a 25%+ FCF yield on the enterprise value, as compared to a 10-year treasury rate of less than 4%, which hopefully compensates for some of the risks here.

One meaningful risk is that management makes poor use of the company’s excess cash, especially since cash now represents about 60% of current market cap.  CEO Simon Nynens is young but has been with the company a long time.  He was formerly the CFO and an operating executive with the company before that and has been intricately involved with the company for the entire turnaround in operating results since 2002.  Readers can listen to conference calls or read transcripts to reach their own opinion but our sense is that he will be a reasonable steward of the company’s capital.  He is clearly aware of the stock’s poor performance and that cash represents a large portion of the market value.  He also appears very committed to growing gross margin dollars while holding the line on operating expenses and not chasing unprofitable sales with VMware or other software vendors.  He repeatedly points out that management’s complete focus is on growing net income and not growing sales.  He also recognizes the company’s cash balances are providing a very low return but does not seem in any rush to overpay for an acquisition, especially in this economic environment.  He also points out that, because the company is such a small niche player, management cannot use the economy as an excuse for underperformance.  We applaud his actions to date.  The Board also recently authorized an additional 500,000 share repurchase program bringing the total current share repurchase program to over 600,000 shares or over 12% of diluted shares.  The Board also has some other financial types with meaningful stakes in the company who would hopefully step up to question a dilutive acquisition or some other poor use of capital.  All this said, we can’t provide any iron-clad guarantees on this topic.

Recent financial information for WSTG is presented below ($mm’s except per share amounts):

 

Major shareholders
Edmund Shea	276	5.9%
ROI Capital Mgmt	268	5.7%
Steven Emerson	263	5.6%
Al Frank Asset Mgt	234	5.2%
Simon Nynens	219	4.6%
Wellington Mgmt	196	4.1%

 

Segment Analysis
				6mos	6mos
	2005	2006	2007	2007	2008
Revenue
Programmers Paradise	$53.70	$53.70	$44.80	$21.20	$24.20
Lifeboat	$84.00	$128.60	$135.10	$69.80	$64.40
Total	$137.70	$182.30	$179.90	$91.00	$88.60
Gross profit
Programmer Paradise	$7.40	$7.30	$5.80	$2.90	$2.80
Lifeboat	$7.60	$9.70	$11.50	$5.90	$5.20
Total	$15.00	$17.00	$17.20	$8.80	$8.00
Direct costs
Programmers Paradise	$4.20	$3.40	$2.90	$1.50	$1.40
Lifeboat	$1.80	$2.20	$2.90	$1.40	$1.50
Total	$6.00	$5.60	$5.80	$2.90	$2.90
Income before taxes
Programmers Paradise	$3.20	$3.90	$2.90	$1.40	$1.40
Lifeboat	$5.80	$7.50	$8.60	$4.50	$3.70
Total segment income	$9.00	$11.40	$11.50	$5.90	$5.10
General and administrative	$6.20	$6.70	$6.30	$3.20	$3.10
Interest income	$0.30	$0.70	$1.00	$0.50	$0.40
Income before taxes	$3.10	$5.50	$6.10	$3.30	$2.40
Assets by segment
Programmers Paradise		$7.10	$8.60	$6.60	$10.00
Lifeboat		$22.20	$17.30	$16.60	$17.50
Corporate assets		$28.00	$30.80	$26.50	$30.60
Total assets		$57.30	$56.80	$49.70	$58.10

 

Consolidated Financial Statements
							6mos	6mos
FYE 12/31		2003	2004	2005	2006	2007	2007	2008
Net sales		$69.57	$103.58	$137.66	$182.32	$179.87	$90.96	$88.60
Cost of sales		$60.61	$91.24	$122.69	$165.35	$162.63	$82.17	$80.56
Gross profit		$8.96	$12.34	$14.97	$16.97	$17.24	$8.79	$8.04
SG&A expenses		$8.14	$10.17	$12.20	$12.16	$12.08	$6.03	$6.02
Operating income		$0.82	$2.17	$2.77	$4.81	$5.16	$2.76	$2.02
Interest income		$0.24	$0.11	$0.30	$0.74	$0.99	$0.49	$0.38
Other		$0.00	$0.00	$0.00	$0.00	$0.00	$0.00	$0.00
Income before taxes		$1.06	$2.28	$3.07	$5.55	$6.15	$3.25	$2.40
Prov. for income taxes		$0.08	($4.04)	$0.41	$2.28	$2.44	$1.30	$0.96
Net income		$0.98	$6.32	$2.66	$3.27	$3.71	$1.95	$1.44
EPS - Diluted		$0.25	$1.51	$0.61	$0.72	$0.80	$0.42	$0.32
Diluted Shares o/s		3,900	4,180	4,384	4,521	4,656	4,687	4,519
Gross margin %		12.9%	11.9%	10.9%	9.3%	9.6%	9.7%	9.1%
SG&A %		11.7%	9.8%	8.9%	6.7%	6.7%	6.6%	6.8%
Operating income %		1.2%	2.1%	2.0%	2.6%	2.9%	3.0%	2.3%
Income before taxes %		1.5%	2.2%	2.2%	3.0%	3.4%	3.6%	2.7%
Net income %		1.4%	6.1%	1.9%	1.8%	2.1%	2.1%	1.6%

Quarterly Segment Analysis
		Q3 06	Q4 06	Q1 07	Q2 07	Q3 07	Q4 07	Q1 08	Q2 08
Sales
Programmers Para		$17.2	$11.8	$10.8	$10.4	$11.0	$12.6	$11.2	$13.1
Lifeboat		$31.5	$45.1	$36.1	$33.7	$30.8	$34.5	$29.3	$35.0
Total		$48.7	$56.9	$46.9	$44.1	$41.8	$47.1	$40.5	$48.1
Gross profit
Programmers Para		$2.1	$1.6	$1.6	$1.3	$1.4	$1.5	$1.4	$1.5
Lifeboat		$2.3	$3.1	$2.9	$3.0	$2.7	$2.8	$2.4	$2.8
Total		$4.4	$4.7	$4.5	$4.3	$4.1	$4.3	$3.8	$4.3
Gross margin %
Programmers Para		12.2%	13.6%	14.8%	12.5%	12.7%	11.9%	12.5%	11.5%
Lifeboat		7.3%	6.9%	8.0%	8.9%	8.8%	8.1%	8.2%	8.0%
Total		9.0%	8.3%	9.6%	9.8%	9.8%	9.1%	9.4%	8.9%