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.
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.
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.
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
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.
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)
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)
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
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.
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.
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.)
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
Table 6: Implied Returns (Average 84.5%)
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
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.
- 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