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AEY Report Graham Net Nets Dec 2011

AEY Report Graham Net Nets Dec 2011

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Published by: Jae Jun on Dec 06, 2012
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VarianADDvantage Technologies (AEY)
Stock Price $2.02Net Current Assets:
Tangible Book Value
ADDvantage Technologies (AEY)
is an interesting company. It’s been written about on
several excellent value investing blogs recently
includingWhopper Investments and Oddball Stocks.They came to different conclusions about the stock. But they both madegood points. Whopper Investments points out ADDvantage has historically been a muchbetter business than most net-nets. Oddball Stocks points out that sales have fallen off a cliff.And the business is changing because of a new agreement with Cisco. More on all this later.But first we need to lay out the numbers. Like every stock this newsletter picks, we start with
asset values instead of earnings power. Here’s what
you get with every share of ADDvantageyou buy:
Surplus cash equal to 58% of the stock price
Net current assets equal to 127% of the stock price
And tangible book value equal to 163% of the stock price
Surplus cash does not mean net cash here. ADDvantage has no net cash in the sense of cashminus total liabilities. But it does have $12 million of cash on its balance sheet. Normally,the company holds almost no cash. The increase in cash is due to a large sales decline causedby a decrease in cable company capital spending since the end of 2007
basically the GreatRecession
and a new deal with
Cisco (CSCO)
which changes the way AEY buysinventory. These forces have combined to move $12 million into cash that would normally
 be put right back into inventory. It’s been AEY’s policy to invest all of its cash flow into
more inventory. The idea was to always grow the business both in terms of overall sales and
in terms of the breadth of the inventory available to be shipped next day to AEY’s 1,600
cable company customers. When the growth music stopped in 2007 and then Cisco changedthe agreement
there was simply no place to put this $12 million in cash. So AEY has about$1.18 a share in cash that could be used to buy back stock, pay a dividend, or pay down debtif the company wanted to do those things. It did buy back stock recently. And managementincluded language in the most recent 10-K and 10-Q making it clear they believed their stock price was too low relative to their future prospects. Hinting obviously that they might buy
 back more stock with any cash that can’t be put into inventory growth like it used to.
What’s with this whole inventory growth strategy?
Good question. Long time readers of thenewsletter will remember
Lakeland Industries (LAKE)
. I picked that stock early this year.And ADDvantage is a lot like Lakeland. Both companies have long histories of consistent
..........Page 1
..Page 6
What is a Net CurrentAsset Bargain?
A net current asset valuebargain—or net
net—is astock selling for less than thevalue of its current assets—cash, receivables, andinventory—minus allliabilities. Basically, it’s astock selling for less than itsliquidation value.
©Copyright 2011 by Gurufocus.com, LLC2
Ben GrahamNet Current Asset Bargains
 profitability. ADDvantage’s streak is longer at 25 straight
years of profits. The company
hasn’t lost money since it was bought out of bankruptcy by the C
hymiak brothers
who stillown just under half the company
back in 1985. The actual predecessor company is Tulsat
 now a subsidiary of ADDvantage
that went public through a 1999 reverse merger. TheADDvantage name is the result of that reverse merger. It has nothing to do with the operatingcompanies we are talking about here. Or their history. For those facts, you have to researchTulsat. Today, Tulsat
is just one of ADDvantage’s regional subsidiaries.
They now haveothers in Nebraska, Texas, Missouri, Georgia, and Pennsylvania. But these are all really justextensions of the original idea. Even the Tulsat name has been carried over to new locations.So you have some odd sounding subsidiary names like Tulsat-Atlanta.What you need to know is this. ADDvantage as it exists today traces its roots to its twocontrolling owners
who happen to be brothers
and a company called Tulsat. The business
has been consistently profitable. It’s been growing – 
up until the last few years. And it’s
always been in need of more and more inventory. Just like Lakeland. In both cases, you havedecent and consistent operating profits combined with non-existent free cash flow becauseworking capital
especially inventory
is constantly growing.ADDvantage has a good reason for holding so much inventory.
There’s no disputing that up
until now ADDvantage has achieved much higher returns on capital
and fat operatingmargins
through its inventory strategy.
It’s the core of what the company is. As
management puts it, their products are:
“On Hand – 
On Demand”.
This makes ADDvantage an also ran when it comes to big orders. Who would buy fromADDvantage when you could buy from Cisco instead?Nobody. Unless you have a small order. And you need it shipped today. Cisco can
’t ship old
or hard to find inventory. Original equipme
nt manufacturers don’t do that. They aren’t aboutsmall, quick, and local. They’re about centralized and standardized business. They don’t
keep small batches of important but no longer cutting edge products stowed away in differentparts of the country waiting for customer orders.
The part that probably confuses most people about ADDvantage’s business is who these
customers are. Why would they order from someone who is obviously more expensive?ADDvant
age doesn’t claim to sell Cisco’s products for less than Cisco does. They admit they
charge more. But they have it in stock. And they ship it today.ADDvantage sells to about 1,600 cable companies around the United States. They also dosome business in Latin America. But
we’re not going to worry about that. In the U.S., no
customer is particularly important to ADDvantage. Their largest customer accounts for 7%
of sales. And their top 5 customers together don’t even add up to 25% of sales. But that’s
looking at things backwards. What really matters is how important ADDvantage is to theircustomers.
ADDvantage does not seek to be any company’s sole supplier. And ADDvantage doesn’t
operate on the cutting edge of new technology. In fact, the company just wants to replace
 products for its customers. It never tries to “sell them” on a new product.One indication of ADDvantage’s position in the industry is that customers will call ahead of 
adverse events
like bad weather
that they know will damage their system. They want to
©Copyright 2011 by Gurufocus.com, LLC3
Ben GrahamNet Current Asset Bargains
 be sure they can have the lowest downtime possible. Ultimately, it’s down
time reduction thatADDvantage is selling. Not just Cisco products. But protection against excessive downtimecaused by a lack of Cisco products.
I should mention that I’ve used Cisco as an example here to help you visualize the product – 
I assume you’ve
seen Scientific-Atlanta products before
and not because Cisco literally
accounts for almost all of ADDvantage’s inventory. It actually makes up about 35%. Far 
more than anyone else
Motorola is only 7%. But actual products and sales at ADDvantageare a bit of a hodgepodge. New product sales are around two-thirds of all sales. The rest arerefurbished products and repair services.
That’s what these regional locations are.
ADDvantage ships and repairs from them.
That’s why they need to be in different pla
cesaround the country.
Anyway, that’s ADDvantage’s competitive strategy. You can like it or hate it. But it hasworked in the past. The company’s 10
-year average return on invested tangible capital isabout 22% pre-tax or more than 14% after-tax.
very high for a company with 30%gross margins. Or for a reseller of any kind. In fact, a 14% after-tax return on assets isusually associated with a stock trading at more like 2 times book value rather than two-thirdsof book value.Obviously, invest
ors are pricing in a huge reduction in ADDvantage’s return on assets,
margins, etc. in the future. They could be right. The new Cisco deal is clearly a negative.
However, I’m unconvinced about either the idea of a decline in cable TV hurting
ADDvantage or the idea that the huge sales drop in the last few years was due entirely tocompany specific factors. Housing starts fell to almost nothing.
There’s been no reason for 
cable companies to spend money. As for a long-term decline in cable TV
obviously thatwill happen. Fewer homes will watch cable TV. The number of households in the U.S. withTVs is expected to drop
by about 1%
this year for pretty much the first time ever.
But ADDvantage serves cable companies. It doesn’t serve cable TV.
Whether cablecompanies will be providing fewer triple play
internet, TV, and phone
services is a
different question. And it’s a hard one to answer. There’s certainly no devastatingly obvious
trend in terms of how many
cable company products will be in people’s homes.
There maybe fewer TVs. But will there be less internet?
ADDvantage isn’t just an asset value bargain. It’s
a very cheap earning power bargain. To
give you some perspective, at the company’s 10
-year average pre-tax return on investedassets of 22% and a tax rate of 35%
ADDvantage would earn more than a 14% return onequity even if it used no leverage. A 14% return on equity is completely inconsistent with acompany trading at less than book value. So, folks seem to be pricing in a decline of something like two-thirds of ROE.Anything is possible. But the kind of returns on assets needed to justify a stock price wellbelow book value
are so far below ADDvantage’s historical returns on assets that you would
need to feel pretty certain ADDvantage was going to earn much lower returns in the futurethan it has in the last few years.Considering that we are living in a time of high unemployment, low housing starts, and closeto non-existent household formation
you’re really saying that ADDvantage’s business has
to deteriorate in a way that more than makes up for the inevitable bounce back in cable

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