Friday, November 6, 2009

The Inventory ADDvantange

A company that makes for a good investment for one value investor does not necessarily make for a good investment for another value investor. How can this be? A company may appear cheap on an earnings or asset basis, but future earnings may not live up to current earnings and assets may be written down. Therefore, only when a company falls within an investor's circle of competence can he ascertain whether a stock is trading at a discount.

Consider ADDvantage Technologies (AEY), a hardware provider for the cable television industry. The company is cheap on many metrics, trading near its net current asset value with a P/B of 0.75 and a P/E of 6. Though sales have fallen dramatically through this downturn, the company has maintained profitability.

Of importance is the company's strategy, however. The company does not manufacture much of the equipment it sells, but is instead a distributor, servicer and value-added reseller to cable companies. One of the major ways in which it adds value for its customers is with its large inventory, allowing for fast delivery of large orders. But the amount of inventory the company carries is far from trivial: it represents 90% of the company's current assets, two-thirds of the company's total assets, and is greater than the company's total equity.

For value investors, the company's strategic decision carry so much inventory has important implications. From one vantage point, the large inventory may represent a margin of safety, as investors are currently afforded the opportunity to purchase this company for less than its inventory. From another point of view, however, the inventory carries a major risk of obsolescence.

Confidence can be placed in the value of inventories of durable goods in slow-changing industries. For example, $30 million worth of screws, nuts and bolts can probably hold their value. But $30 million worth of laptop computers will eventually have to be written down. In which category does the inventory of AEY fall? That depends on the investor's circle of competence.

It is not enough to be able to interpret management's comments on the current value of the company's inventory. Carrying such a large inventory is a major part of the company's strategy going forward, and so cash received from customers will be pumped back into inventory on an ongoing basis. As such, the investor will be constantly subject to the risk of obsolescence. Therefore, only an investor who understands the nature of AEY's products and the speed at which the technology changes can value the company's inventory to some degree of certainty. For everybody else, an investment in this company contains an element of speculation.

Disclosure: None


Anonymous said...

Enjoy the blog... keep up the interesting stuff. I thought I'd try to get a discussion going about a company you've written about, Parlux Fragrances.

As you know, they reported earnings this week. The balance sheet shows ~$5.50 in book value, mostly made up of cash, receivables, and inventory. On the conference call, the company suggested the receivables are relatively clean, inventory from Guess is being liquidated (at roughly breakeven), and of course, cash is cash.

The stock trades for $2/share (rounding off here). Let's say a small company like this is worth 8x normal earnings over time. That would suggest normal earnings of $0.25 given the current stock price.

Again using an approximation, that equates to an expectation from the marketplace that the ROE on these assets (as stated) is less than 5% "normalized" (4.5% is more accurate).

Shouldn't shareholders be pushing for a liquidation in this case? Should any company exist that has a "normalized" expectation of less than 5% ROE?

I'd be curious for your take. Thanks in advance

Saj Karsan said...

Hi Anon,

Interesting way to look at it. While I agree that a company that earns ROE of less than 5% should try to shrink rather than grow, I'm not sure assuming a rational stock price is prudent. Last year around this time, the stock price was $5 instead of $2, so by your calculation normalized earnings estimates would have ROE at 10%+. The stock price will fluctuate wildly, therefore deciding whether to liquidate solely on that basis is probably not sound practice.