Sold off Avnet this morning. I was lucky to be on the IB app at a 7% pop this morning. So I got rid of the stock at $50 for a total gain of 23% since it was added back in August. I may or may not add it back to the portfolio depending on what I’m able to find during this screening process. The only stock remaining on the long side is MNDO. The total portfolio is now 85.7% cash.
Avnet announced its intention to sell its Technology Solution (TS) segment to Tech Data ($TECD). If you haven’t read the original thesis for Avnet, you can do so here. Tech Data rose sharply (about 20%) which indicates that the markets believe that Tech Data got a good deal. Avnet also rose sharply (about 7%), but has given back those gains.
- Avnet gets $2.4 Billion ($2.0B after taxes) in cash and 2.8 million shares of Tech Data.
- The deal is expected to close in the first or second quarter of 2017.
- This will offset the recent Premier Farnell acquisition (assuming both deals close).
- Management expects to record between $3.75 and $4.75 gain in FY 17.
Post both deals closing, we should expect a 35% drop in revenues and a 28% drop in net income on the low-end. Management also excluded $25 million in synergistic benefits. I’m generally skeptical about synergies because the majority of acquisitions either destroy or add no value to the acquirer – although they always seem to cite cost saving synergies as the rationale for the acquisitions.
Post both deals, Avnet will carry $2.8 Billion in cash and $3.6 Billion in debt. Given that majority of the cash is in the U.S. and majority of the debt is abroad, it only makes sense to me that the company keeps and services the debt internationally while utilizing the cash to either pay dividends or repurchase stock domestically. Total debt ($3,400m)/Operating Income ($730m) going forward will be 4.66 and given that majority of the income stream, and the debt are abroad, it makes no sense to pay down debt with the cash proceeds. They could service that with the international income stream while repurchasing shares in the United States since they’d have to pay 40% taxes to just bring the money back into the country. The current cash balance from the TS sale alone could repurchase 40% of the current market cap, so I’m hoping the board chooses this direction.
I left out a slew of things I don’t think particularly matters to the bull case for Avnet. Both Avnet and Arrow have spent quite a slew of money on acquisitions since the financial crisis, but Arrow has spent about 50% more, so Avnet is in a conservative position. They both haven’t seen any organic growth over the past five years, but it looks as if Arrow has been growing. In an industry with a P/S ratio of 0.2, the smallest acquisitions make a decent contribution to the top line – every acquisition matters. Also, Avnet made over 90% of its purchases before the June 2013 quarter when valuations were still reasonable, unlike arrow whose acquisitions have been spread out. Also, Avnet has an interim CEO. I don’t think this matters, however, because comps either lap or they don’t. The CEO won’t change this. In fact, he faces an easier road than his predecessor given how bad things are today.
Avnet Inc. distributes electronic components, computer and storage products, and provides IT Solution and Services. The Company operates in two segments:
- Electronics Marketing (EM)– Markets and sells semiconductors and other embedded devices for electronic component manufacturers.
- Technology Solutions (TS) – Works with business partners to deliver more effective and efficient supply chain and IT lifecycle solutions.
Organic sales rose 0.7% in Q1 and fell 5.5% and 7.2% in Q2 and Q3. The company has a long history of profitability (except non-cash write-downs) and trades at TTM P/E of 9.85x.
IBM consisted of 11% of the company’s revenues last year. There is an apparent risk that IBM, could out of the blue, decide to switch to a different distributor. I don’t see this as a problem, however, because:
- Distributors tend to have very little operating leverage.
- When a client is this significant to a company, they tend to provide lower than average margins to that company. Which means a loss of the customer won’t be particularly disastrous to the company from a bottom line perspective as it would from the topline.
- This is typical in the industry. Large technology tends to diversify amongst distributors to avoid any significant delays in the event one fails.
Avnet distributes physical computer software, and given the industry trend towards the cloud, it’ll prove to be ultimately detrimental. The other side of the coin is that the computer products are concentrated within the Technology Solutions segment. Below, are unadorned breakdowns of revenue and operating income for both EM and TS:
Within the operating expenses, there is ‘corporate’ which is overhead. The operating income numbers for each segment in FY 2015 was $797.4M for EM, $325.7M for TS, and $150.6m for corporate. If we conservatively net out TS and Overhead, we’d be left with a total operating income of $321.1M. Assuming a 30% tax rate, net income would equal 224.7. That would give Avnet a P/E of 23, on par with the S&P 500. The above is extremely conservative and doesn’t take the following into account:
- The TS segment also contains enterprise computing servers, storage, Hard disk drives, Microprocessors, motherboards, DRAMs, other services along with Software. Although management doesn’t break this number out, I’m doubtful software accounts for even half of the TS segment. Arrow Electronics, which is a direct competitor breaks this down and according to last fiscal year’s annual report:
Within the global ECS business segment, approximately 39% consist of software, 35% of the company’s sales consist of storage, 9% consist of proprietary servers, 9% consist of industry standard servers, and 8% consist of other products and services.
The ECS segment is comparatively equivalent to Avnet’s TS segment. In 2015, approximately 62% of the company’s sales were from the global components business segment and approximately 38% of the company’s sales were from the global ECS business segment – they literally have the same exact revenue proportions. I believe a more appropriate number to use for software is 39%, the 100% is quite conservative.
- Time value of money – While the software portion may be declining, it isn’t gone and will still provide cash flows to the company. The above conservatively assumes that the software portion goes away today.
Easier Comps within the Semi-Conductor Industry
EM segment is approximately 81% semiconductor – The semiconductor industry is facing severe headwinds today, and the revenue declines should make next year’s comps easier to beat. My target for this is Q2 – that quarter was the first and sharpest sales drop. Sales in China fell 10.3% in FY 16 after rising 7% in FY 15 and the company, like others who have been affected by the China slowdown, face easier comps so, we might see some stabilization in Q2 of FY 17.
Balance Sheet, Absolute & Relative Valuation
The company carries $1 Billion in cash and has $9 Billion in Current assets (Including cash). Excluding cash, we have $8 Billion. Liabilities total $6.5 Billion. If we subtract the $6.5 billion from $8 Billion, we get $1.5 Billion. This means that net of cash, the company would still have $1.5 Billion worth of equity after subtracting all liabilities and also conservatively assuming that the company’s non-current assets are worth nothing. Now, if we subtract the $1 Billion from the company’s $5.1 Billion market cap, we get $4.1 Billion. The company made $507 Million last year for a 12.7% earnings yield or a P/E of 7.87 which is relatively cheap compared to both its competitors and the general market.
But to compare them, Arrow, too, has $9 Billion dollars in current assets. If you net the $500 million cash, we have $8.5 Billion. Liabilities total $8.5 billion, which means you can eliminate them, but without any equity for a margin of safety. The company made $500 million last year, the market cap today is $6 billion, or $5.5 Billion net of cash for a P/E of 11 or earnings yield of 9.1%.
Avnet has $1.5 Billion of equity after netting current assets without cash; Arrow has none. This 1.5 Billion is significant because it’s about 30% of Avnet’s market cap. Today’s buyer would get $1.5 Billion of extra equity + the $1 Billion in cash, or $2.5 Billion liquid equity compared to Arrow’s $500 million liquid equity. Avnet has a market cap of $5.1 Billion, while arrow has a market cap of $6 Billion. This is provided that Arrow’s revenues have been relatively stable over the past year while Avnet’s plunged. Avnet is indeed cheaper for a reason, but if we do see revenues stabilized, the valuation gap should close. If we don’t see revenues stabilize, then market already expects disaster from Avnet anyways. So this is more of an ‘If I’m right, I win big, if I’m wrong, I don’t lose much’ scenario. The intelligent investor would be receiving over 10% earnings yield today from Avnet while we wait for better days.
There’s no solid catalyst for Avnet, but I believe the company could also potentially be an acquisition target given its valuation. My cost basis on this position is $40.45, and my price target is $55. I have set a limit order to increase this by 20% if the stock falls below $40.
I was so tired I crashed after work, I should have the Avnet post up tonight. Also sold off a portion of $BDL, the portfolio has 18% equity in the stock. PFIN reports tomorrow and not today. I’ve sold my position, and the portfolio now holds 49℅ cash.
So for a two-week recap – Sold SODI, PFIN, PFHO – Bought AVT, small Canadian Company.
Long: AVT, BDL, MNDO, GH, small Canadian company.
I’ll update the homepage this weekend.