AEY – ADDvantage Technologies Ltd.

Company Profile

The business was founded in 1985 by the same management team that is operating currently. The company has grown organically as well as by acquisitions. The stock was listed on NASDAQ in 2007.

From the company website, we read the following description:

We are a supplier of a comprehensive range line of electronics and hardware for the cable television (“CATV”) industry (both franchise and non-franchise, or private cable). Our products are used to acquire, distribute and protect the broad range of communications signals carried on fibre optic, coaxial cable and wireless distribution systems. These products are sold to customers providing an array of communications services including television, high-speed data (internet) and telephony, to single family dwellings, apartments and institutions such as hospitals, prisons, universities, schools, cruise boats and others.

AEY’s business model and competitive edge is based on the idea of “On Hand, On Demand”, i.e. having a large inventory to quickly service client request. This allows it to generate higher margins than its peers but also forces AEY to carry higher inventories.

The company has distribution agreements with the largest OEMs, such as Motorola, Cisco, and most recently Fujitsu Siemens. The long term strategy is to grow the business and reinvest all earnings. Hence AEY does not currently pay or intends to pay any dividends.

Investment Thesis

AEY presents a compelling investment opportunity due to the following factors:

  • Valuation: Current market value of $22.3m below book value of $35.2m and net current assets of $37.7m
  • Revenue and margins are at depressed levels providing downside protection
  • Experienced and incentivised management
  • Potential upside due to efficiency improvements and growth opportunities

We think the market is too focused on the most recent quarters that were disappointing in terms of revenues and earnings. The longer term picture remains very solid, presenting a good entry point for a potential investment.

Current Market Valuation

The current market value of the stock is severely depressed relative to fundamentals. AEY trades at less than book and net current asset value. Usually these characteristics are found in companies that operate poorly, destroying shareholder capital. However, AEY is profitable and maintained profitability through the financial crisis. More importantly it has maintained relatively high operating margins, reflective of its robust business model.

As most of AEY’s capital is invested in the relatively large inventory, this is where we believe the market gets it wrong.

Inventory

AEY’s strategy is to maintain large amounts of inventory to meet demand quickly and effectively. While they cannot compete with the large OEMs such as Cisco or Motorola, on price, they can be the first choice when a customer has an immediate need.

The inventory mix includes new and used or refurbished products with the former currently representing 70% of total inventory. The figure below shows the historic split of the inventory types.

image

Source: AEY Annual Reports

As visible from the chart, reserves as a percentage of total inventory have increased quite significantly from a cycle low of 2.2% in 2007 to currently 8.3%.

In 2010, AEY significantly increased cash reserves by reducing stock purchases in response to the continued depressed capex environment as well as historically low housing starts. The company believes it is well funded to meet future working capital requirements. We believe this to be a fair assumption based on the cash flows generated over the last decade together with the line of credit available.

While we cannot exclude the possibility, the likelihood of AEY having to liquidate its inventory is extremely low. If it managed to stay profitable through the worst financial crisis then we can expect that it will continue to operate going forward. In fact, AEY has improved its balance sheet and liquidity position in almost all aspects.

Table 1: Liquidity and Solvency Ratios

image

While the inventory turnover is relatively low at 1.6, AEY could essentially turn the existing stock into cash within a year, leaving cash left over for shareholders.

As such we believe, based on current market and book values, that AEY is significantly undervalued as the market is undervaluing the earnings power and discounting the large inventory by too much.

Industry Dynamics

While AEY is classified as a technology company, its role is more like a distribution agent supplying technology companies with equipment. This isolates AEY somewhat from the fast changing nature of the technology space. If a new technology for cable companies comes on the market then AEY can simply adjust its inventory. Of course there is a risk that its old inventory becomes obsolete if the industry change takes place very quickly. Yet the cable industry is a capital intensive business where changes cannot happen as quickly as adopting a different social network. What is impacting AEY is the current downtrend in capital expenditure.

The cable industry has been reducing capital expenditures for the past 3 years in a row. However there is a steady maintenance demand

Figure 2: US Cable Industry Capital Expenditure (in $bn)

image
Source: SNL Kagan

Also the extremely depressed housing market is impacting AEY sales. However, even with households consolidating and the large overhang of unsold housing inventory, one can assume that the current rate of housing starts is unsustainable in a country where population continues to grow each year. This is not to say that house prices will rise.

Figure 3: New Privately Owned Housing Units Started (in 000s)

image

Source: US Census

If we combine these factors it is not surprising that overall earnings are down significantly since the peak of the crisis. However, AEY has maintained strong gross profit margins. Of course due to some operating leverage, net margins have declined to historic lows. This provides a margin of safety to an investor as he invests in a strong profitable business at or near the bottom of the cycle.

Table 2: Profitability Ratios

image

Management Discussion

David and Kenneth Chymiak have been basically running the firm since 1985. They both own a large share of the outstanding stock. Total Insider ownership is 47%. Management of the company has been in place since 1985 when the brothers. While on the one side it is good to see management to have that much invested in their own firm, on the other hand it creates some conflicts of interest. In fact some of these were outlined in the Annual Report from the 2008 Annual Report discussion of Risk Factors:

David Chymiak, Chairman of the Board, and Kenneth Chymiak, President and Chief Executive Officer, owned approximately 46% of our outstanding common stock. Our performance is highly dependent upon the skill, experience and availability of these two persons. Should either of them become unavailable to us, our performance and results of operations could be adversely affected to a material extent. In addition, they continue to own a significant interest in us, thus limiting our ability to take any action without their approval or acquiescence. Likewise, as shareholders, they may elect to take certain actions which may be contrary to the interests of the other shareholders.

While this sounds more like a general disclosure, It warrants digging into more detail, given the size of the insider ownership and the small market capitalization of the stock.

First of all compensation for the Chief Executives is relatively high and secondly there is an on-going related party transaction. AEY is leasing a warehouse which is owned by David Chymniak. The current monthly rent is significantly below what AEY pays for other properties. However the brothers used to be involved in real estate development so this might be a legacy issue. In addition the lease payments of $7,500 monthly are not significant enough to warrant concern. in addition their compensation is tied to EBIT levels, which ties their incomes with the profitability of the firm.

Potential Growth Opportunity

Management outlines several ways to improve long term growth prospects. To be prudent we did not include these in our valuation or investment case. Nonetheless some of these present real opportunities that could greatly enhance shareholder returns.

image

Some of these initiatives, we would view as merely required to keep up with competition and maintain existing margins and sales, while others represent real opportunities for AEY to deliver additional growth in addition to general market trends.

One of the more promising areas is the further expansion into Latin America. While as a percentage of the total this still represents only a part of AEY’s revenue, the opportunities are much greater. The Latin American market is much less saturated in terms of cable customers and existing cable equipment. Sales in the US are primarily the result of upgrading/replacing existing equipment, while demand from Latin America is growing much more quickly.

Management has been trying to establish major distribution agreements for Latin America for quite some time. So far its efforts have been unsuccessful, as the latest renegotiation with Cisco did not include the Latin American market. Nonetheless AEY has been growing foreign sales quite significantly over the past 5 years.

From 2005 to 2010, foreign sales increased by 183%, while domestic sales declined by over 15% (23.2% and -3.3%pa). If Management succeeds in signing a major distribution agreement, this would provide a significant boost to sales and subsequently to the bottom line.

image

Valuation

Assuming going concern we first value AEY based on a modified (i.e. more conservative) Graham formula. We use 7.5 (instead of 8.5) as our no growth P/E Ratio. A growth rate which is based on the linear trend of of the past 10 years of 2% and finally normal earnings of $0.42ps which is the arithmetic 10 year average

Figure 4: Historical Earnings per share and linear trend (1.9% p.a.)

image

The Bond yield within the Graham formula is assumed to equal the current AA corporate rate of 4.8%. This leaves us with a fair value estimate of $4.02, significantly above the current market price of $2.23, implying a margin of safety of approximately 45%. It is important to note at this stage that we are being very conservative in valuation assumptions.

Table 3: Sensitivity Analysis

image

Table 6: Implied Returns (Average 84.5%)

image

Alternatively we looked at historical valuation ratios to assess the current fair value. Historical average P/E is around 8 which would imply a fair value stock price of $3.36 using normalized earnings as mentioned above. P/TBV implies a similar margin of safety.

Figure 5: Historical P/E and P/Tangible Book Ratios

image

Overall we believe AEY provides a significant margin of safety, with tangible assets backing up shareholders equity. At current market prices on essentially buys the inventory at a discount with free participation in future growth.

Risks

  • Swift change in technology which leads to large amounts of AEY’s inventory to become obsolete.
  • Further significant economic weakness causing AEY’s clients to further hold back capital expenditure
  • Declining home starts and resulting loss of demand for AEY’s products
  • Problems with one of AEY’s lead suppliers Cisco or Motorola

Africa – Lost Cause or Investment Opportunity

by KS

I’ve been doing a bit of research (i.e. reading) into Africa. My interest was first sparked by an interesting article on tilt.ft.com regarding Investment Opportunities in – yes that’s correct – Zimbabwe. It was written by Graham Stock from UK-based Hedge Fund Insparo Asset Management. It is a very concise article and well worth a read.

Zimbabwe

In summary their view was that despite the ongoing political worries, the country and its economy have seemed to reorganize themselves around those issues. After essentially abandoning their domestic currency in February 09 in favour of foreign issues, such as the South African Rand, Botswana Dollar and of course the US Dollar, hyperinflation has been tamed. Wikipedia provides a good description of what has been happening with regard to domestic monetary system. Based on IMF data YoY inflation has come down to ~5% with the latest reading for November being 4.2% according to a Reuters article.

Summary Economic Statistics

2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
Real GDP (% YoY) -8.4 -5.6 -10.6 -4.2 -7.7 -4.6 -5.5 -14.5 4 2.2
CPI
(% YoY)
75 135 385 381 267 1,034 12,563 56bn 6.5 5
Trade Deficit (USDm) -323 18 108 305 388 467 310 997 1,607 1,397
External debt (USDbn) 3.6 3.9 4.5 4.8 4.3 4.7 5.3 5.8 7.1 7.6

Source: IMF; The Reserve Bank of Zimbabwe; EIU; World Bank, Harare.

The article continues to quote some significant improvements in economic indicators, such as bank deposit growth (deposits rising from $20mm in February 2009 to around $2bn this year). It even seems that their agriculture sector is slowly recovering after Mugabe almost destroyed it. Maize crop has risen from 400,000 tons in 2008 to 1.3 million in 2010. While this is still far of from Zimbabwe past production levels (it used to be called Africa’s food basket), it at least provides a level close to self-sufficiency. Zimbabwe’s farming sector can produce, and has produced in the past, exportable surpluses of maize. But severe constraints on prime land use have resulted in less than full capacity utilization of its natural resources. However, since the economic reforms, farmers are better equipped to plan and prepare for the season, as a result of the comparatively steady inflation rate. In conjunction with the large input support programmes partly organised by the UN (Food and Agriculture Organization) that significantly increased the availability of inputs, production increased over the last two agricultural seasons, albeit from a very low base in 2007/08.Maize Production

Source: 1999-2007 CSO, 2008-2010 AGRITEX.

Inquiring minds can find out much more on the website of the FOA for example (www.fao.org)

Reading the ft-tilt piece I remembered a previous article from Ambrose Evans-Pritchard. After quickly googling the keywords I found it on the UK Telegraph’s website. It is a very good description of some positive signs coming out of Zimbabwe.

While I’m highlighting the positive developments here, there is of course a long list of problems in Zimbabwe, such as corruption at almost every level of economic activity. An article by Takunda Mugaga from South Africa’s Financial Gazette provides a very good summary of the issues still facing Zimbabwe. However the rate of change has clearly turned and overall conditions are improving in Zimbabwe. From an investment perspective this stage in the economic cycle generally provides some great opportunities as the tilt.ft.com piece highlights

Broader sub-Saharan Africa

Coincidentally I came across an interesting economic review of African data through the valuewalk blog. It reprinted an article from EU think tank VOX (http://www.voxeu.org) during the same week.  While the piece is a good read in its entirety, it comes down to dismissing the prevailing view that Africa is a lost cause. While the latest UN Millennium Development Goals report states that “”little progress was made in reducing poverty in sub-Saharan Africa”, the authors of the VOX article disagree:

The sustained African growth of the last 15 years has engendered a steady decline in poverty that puts Africa on track to meet the Goals by 2017. If peace is established in the Democratic Republic of Congo, and it returns to the African trend (which is what happened to other African nations that were formerly at war), Africa will halve its $1/day income poverty rate by 2013, two years ahead of the 2015 target.

Moreover, African poverty reduction has been extremely general. Poverty fell for both landlocked and coastal countries, for mineral-rich and mineral-poor countries, for countries with favourable and unfavourable agriculture, for countries with different colonisers, and for countries with varying degrees of exposure to the African slave trade. The benefits of growth were so widely distributed that African inequality actually fell substantially.

While the article provides much more detailed analysis the following graph highlights the massive improvements sub-Saharan Africa has made. It shows real GDP per Capita on the right axis and the poverty rate as measured by the percentage of people living on less than $1 a day on the left axis.

Africa improvements

If anyone would like to find out even more about the economic developments the most recent IMF report on sub-Saharan Africa provides a vast amount of data and interesting charts and analysis

Investment Opportunity

Now I do not want to make the folly mistake of relating economic changes with investment returns. Many academic studies have looked at this relationship and generally concluded that either there is no relationship between economic growth and equity investment returns or that this relationship is even negative, i.e. higher growth produces lower stock returns. I do not want to get into the detail of this but I do want to highlight that it is extremely important to make sure as an investor to focus on the right industries and companies. In that regard finance is a sector that can be expected to grow significantly with GDP per capita expanding. In addition the telecommunications sector is growing rapidly providing an essential infrastructure item for the further development of other more consumer focused industries. Other ideas would include looking at western brands/companies that have a large or growing exposure to African countries. See for example the growing investment of Yum Brands (famous for the KFC fast food chain) into Africa. According to a WSJ story KFC expects to more than double its revenue from Africa within the next 4 years.

Unfortunately it is relatively difficult to gain exposure to African countries other than South Africa. From the above mentioned IMF report comes this chart, showing the massive difference in the relative size of the stock markets.

Africa Stock Capitalization

In addition market liquidity is only 10% of the value of shares traded each year. Countries with reasonable liquidity include Kenya, Mauritius and Nigeria. For people with access to US listed stocks, possible low-cost investments include the two Africa ETFs AFK and GAF. For European investors a possible vehicle includes the Lyxor Pan Africa Fund. All of these have a relatively large weight to South Africa, given its significantly larger market capitalization. Of course to those available there are managed investment funds that focus on Africa such as Insparo mentioned above.

In terms of returns African securities collapsed similar to all other risk assets during the financial crisis. The subsequent recovery starting in March 2009 has been impressive.

AFK Performance

While Investment is difficult ignoring Africa is like ignoring Emerging markets in the 90’s, SE Asia in the 70’s and Japan in the 50’s.

I realise this is obviously not an exhaustive overview of the investment case for Africa, but I hope it at least stimulates some further interest and I am always happy to do some more digging to answer some questions that may come up.

New Year

While we launched the blog last year, there obviously hasn’t been much posted … yet.

One of my New Year resolutions is to finally put more of my thoughts and insights into words to produce some more content for this blog.

Other than that I hope you all had a fantastic 2010, and I’m sure 2011 will be even better.

To get some insight into what the future might hold for us here is an amazing chart from www.nowandnext.com/

Trends_Technology

Welcome

Welcome to NZhedge.com! We hope to bring you lots of interesting articles in the near future, and are keen to read your feedback and comments regarding the topics and the blog in general.

you can contact us by leaving a comment on this blog or directly via email:

ks@nzhedge.com or sc@nzhedge.com or for general enquiries info@nzhedge.com

Let the blogging begin!

Introduction to Rare Earth Elements (REE)

by KS

This post will introduce the investment case for Rare Earth Elements (REE), a very small but exciting natural resource.

It is a group of elements with unpronounceable names like terbium, dysprosium, holmium, cerium, europium and Ytterbium to name just a few. See the graphic below for a complete list of REE. REE are not exchange traded, and requirements are customer specific. The most significant difference between other natural resources is not the exploitation but the refinery process. REE must be recovered as a group and sequentially separated. This is a relatively difficult process and it is not always possible to extract all of the metals from existing ore, i.e. the producer must choose which metals to extract.

Rare Earth Elements

Source: Avalon

2010 global demand for REE is estimated at 136,000t . Demand is expected to grow by around 40% by 2014 from these levels, while supply is relatively constrained given the few potential mining projects.

Applications & Demand

Mined from under the earth, these metals are used in a broad variety of existing technologies, such as hybrid cars, energy efficient light-bulbs, wind turbines and many other uses. For example, each hybrid car has about 15kg of REE inside. This means the Toyota Prius alone uses up 8,100t per year, based on annual unit production of 540,000 units. This is 6% of total annual demand.

REE are not just used in the production of hybrid vehicles but are increasingly being used in gasoline vehicles-emission controls, LCD and PDP displays and are used to make high-strength magnets. The versatility and specificity of the rare earths has given them a level of technological, environmental and economic importance considerably greater than might be expected from their relative obscurity.

Several REE are essential constituents of both petroleum fluid cracking catalysts and automotive pollution-control catalytic converters. The following picture shows a selection of applications in a variety of fields:

REE Applications

Source: Avalon

With these existing applications becoming more popular and research into the uses of REE advancing rapidly, the demand potential is significant. So far, REE are also very hard to replace in the roles they play in these applications

Supply Issues & The Role of China

The Middle East has oil, but China has rare earth – Quote by Deng Xiaoping

Though more abundant than many familiar industrial metals, the REE have a tendency to become concentrated in exploitable ore deposits. Consequently, most of the world’s supply comes from only a few sources.

image

A large share of the global REE production from 1950 through 1990 came from the United States, almost entirely from Mountain Pass, California. From 1990 to today however, the attention shifted to China from several deposits. Even as far back as 1999 and 2000, more than 90 per cent of REE required by the United States industry came from deposits in China. This figure now stands at 97%.

The reasons why China has come to dominate this market are manifold. Unfortunately the primary reason why China could quickly establish itself as the major producer was that it was much less concerned about the drilling methods and its environmental impacts, which allowed it to undercut existing prices significantly. Furthermore, in the last 3 years China has continually reduced the amount of local REE production that can be exported. This has led to a large number of manufacturing firms relocating to China to gain access to these resources, tightening and enhancing the existing supply and production chains. Last but not least China has made moves to buy other rare earth resources around the world. When credit markets collapsed in 2008 China Non-Ferrous Metal Mining (Group) Co. tried to acquire a majority stake in Lynas, which was subsequently blocked by Australia’s Foreign Investment Review Board. The same company then acquired a 25% stake in Arafura.

In July 2010 Chinese officials announced a further 75% reduction in export quotas, increasing global trade tensions. The U.S. has asked business groups and unions to provide evidence that China is hoarding rare earths for a case that may be filed at the World Trade Organization.

Further accelerating the problem, there are little new resources ready to be exploited. Numerous projects are in the pipeline but with the exception of the Mt Weld mine in Australia none are expected to start producing in the next 2-3 years. The following picture from Lynas shows this dynamic. While supply is expected to remain relatively stable demand is likely to significantly exceed existing supply projections.

Supply&Demand

The next chart shows current mining projects in the pipeline. Except for the Australian Mt Weld location, no other projects have even started the construction process.

Project Pipeline

Effects of Imbalances

Shortages can occur when supply as a function of time can no longer keep up with demand as a function of time. At that point, the ultimate recoverable resource in the ground becomes irrelevant. REE seem to have reached this point. Current resources are struggling to maintain production, and growth forecasts are greater than new supply coming to the market. Given the limited supply pipeline expected to hit the market, the scarcity is expected to be an aspect of this industry for at least the next five to ten years. The natural result is that prices for these metals will continue to increase.

REE are generally used in small quantities relative to the overall product. However, REE are also (in most cases) irreplaceable for the particular product. This leads to an interesting price setting behaviour that Dr. Matthew James from Lynas described at an investor conference in the following way:

Secure me the supply of this material , I don’t really care about the price.

REE in New Zealand?

Currently there is no mining of any REE in New Zealand. In addition I am not aware (or couldn’t find references) of any projects or discovery efforts being undertaken.

In a 2007 report of the Institute of Geological and Nuclear Sciences Ltd the authors confirm this view (report available via crownminerals.govt.nz). They acknowledge that REE can be found in New Zealand and that several locations have been identified (see graphic below).  Beach sand deposits near Westport and at Barrytown north of Greymouth contain minor amounts of monazite which could be recovered as a by-product of proposed ilmenite and gold production.

In a separate paper by the Department of Geological Sciences, University of Idaho, the authors discuss the existence of REE in geothermal waters from the Taupo Volcanic Zone.

NZ REE lovations

Investment plays

As REE are not exchange traded directly, exposure must be gained through a mining company. Over 90% of global production is done in China, through either state-owned or private companies. This means the opportunity set is very limited. Of all the rare earth metal miners operating outside China, Lynas (ASX:LYC) is closest to production and is high on investors radar.

Mining the Mount Weld project in Western Australia, the group plans to double production as it moves into the second phase of mining. Lynas is also constructing a plant to process the ore in Malaysia. Mount Weld is touted to have the world’s richest rare earth deposit, and is expected to produce some 1.1 million tonnes of rare earth oxides. That’s enough to supply up to 20 per cent of the global market for 30 years, according to some analysts.

Greenland Minerals and Energy, with access to what it says are probably the world’s largest deposits of rare earth metals and uranium plans also plans to list in London next year. The firm is already listed on the Australian exchange.

In Canada, the best-known junior is Toronto-based Avalon. Smaller Canadian juniors include Rare Element Resources Ltd and Quest Uranium Corp.

Given the recent trade restrictions by China, the sector has seen an impressive rally. Lynas for example has gone up by nearly 170% since the beginning of July!

LYC Stock

Concluding Remarks

I hope this post was as interesting for you to read as it was for me to research and write about. I look forward to any feedback, suggestions, criticism, and/or discussions in the comments section!