AEY Report Graham Net Nets Dec 2011

Varian

ADDvantage Technologies (AEY) Stock Price $2.02

Net Current Assets: $2.56

Tangible Book Value $3.30

ADDvantage Technologies (AEY) is an interesting company. It’s been written about on

several excellent value investing blogs recently – including Whopper Investments and

Oddball Stocks. They came to different conclusions about the stock. But they both made

good points. Whopper Investments points out ADDvantage has historically been a much

better 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 ADDvantage

you 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 cash

minus 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 caused

by a decrease in cable company capital spending since the end of 2007 – basically the Great

Recession – and a new deal with Cisco (CSCO) which changes the way AEY buys

inventory. 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 changed

the 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 debt

if the company wanted to do those things. It did buy back stock recently. And management

included 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 the

newsletter 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

MAY 25, 2011

December 2, 2011 BARGAIN BASEMENT STOCK PICKS FROM VALUE GURUS

INSIDE THIS ISSUE ADDvantage…….......... Portfolio…………………..Page 6

What is a Net Current Asset Bargain?

A net current asset value

bargain—or net-net—is a

stock selling for less than the

value of its current assets—

cash, receivables, and

inventory—minus all

liabilities. Basically, it’s a

stock selling for less than its

liquidation value.

http://www.whopperinvestments.com/add-addvantage-aey-to-your-portfolio-for-some-profits

http://oddballstocks.blogspot.com/2011/10/trying-to-figure-out-why-addvantage-is.html

© Copyright 2011 by Gurufocus.com, LLC 2

Ben Graham Net Current Asset Bargains™ http://gurufocus.com

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 Chymiak brothers – who still

own 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. The

ADDvantage name is the result of that reverse merger. It has nothing to do with the operating

companies we are talking about here. Or their history. For those facts, you have to research

Tulsat. Today, Tulsat is just one of ADDvantage’s regional subsidiaries. They now have

others in Nebraska, Texas, Missouri, Georgia, and Pennsylvania. But these are all really just

extensions 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 two

controlling 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 have

decent and consistent operating profits combined with non-existent free cash flow because

working 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 operating

margins – 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 from

ADDvantage 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 equipment manufacturers don’t do that. They aren’t about

small, 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 different

parts 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?

ADDvantage 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 do

some 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 their

customers.

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



be sure they can have the lowest downtime possible. Ultimately, it’s downtime reduction that

ADDvantage is selling. Not just Cisco products. But protection against excessive downtime

caused 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 ADDvantage

are a bit of a hodgepodge. New product sales are around two-thirds of all sales. The rest are

refurbished 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 places

around the country.

Anyway, that’s ADDvantage’s competitive strategy. You can like it or hate it. But it has

worked in the past. The company’s 10-year average return on invested tangible capital is

about 22% pre-tax or more than 14% after-tax. That’s 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 is

usually associated with a stock trading at more like 2 times book value rather than two-thirds

of book value.

Obviously, investors 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 to

company 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 that

will happen. Fewer homes will watch cable TV. The number of households in the U.S. with

TVs 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 cable

companies 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 may

be 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 invested

assets of 22% and a tax rate of 35% – ADDvantage would earn more than a 14% return on

equity even if it used no leverage. A 14% return on equity is completely inconsistent with a

company 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 well

below 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 future

than it has in the last few years.

Considering that we are living in a time of high unemployment, low housing starts, and close

to 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



company spending that happens when the U.S. economy improves from one of the worst

slumps in decades.

The odds on this stock look badly mispriced. The assumptions to get to sustained earning

power levels that would justify such a low stock price are kind of outlandish.

They’re possible. But we are talking about a company that has never been more liquid and

has maintained better margins and returns on assets than a lot of companies – and almost all

net-nets – achieved during boom times.

A bust for ADDvantage looks a lot like a boom for most net-nets.

So into the model portfolio it goes.

We’ll buy shares of AEY on Monday.

As always, here are some numbers you might find useful.

Vital Signs

Z-Score 4.01

F-Score 5

FCF Margin 7.45%

Pre-Tax Return on Invested Tangible Assets 22.77%

FCF Margin Variation 0.87

Return on Assets Variation 0.32

Z-Score: 4.01

ADDvantage’s Z-Score and F-Score are adequate. A Z-Score above 3 indicates bankruptcy is

unlikely.

Z-Score Ratios

Working Capital / Total Assets 71.42%

Retained Earnings / Total Assets 79.38%

EBIT / Total Assets 14.28%

Market Cap / Total Liabilities 113.18%

Net Revenues / Total Assets 89.40%

Z-Score Calculation Points

Working Capital / Total Assets 0.86

Retained Earnings / Total Assets 1.11

EBIT / Total Assets 0.47

Market Cap / Total Liabilities 0.68

Net Revenues / Total Assets 0.89

4.01



F-Score: 5

The F-Score is a much simpler calculation than the Z-Score. It’s just a checklist. If net

income is positive, cash flow from operations is positive, the year over year change in return

on assets is positive, etc. you award the stock 1 point. If it is negative, the stock gets a zero.

You total the points. The lowest possible score is 0. The highest is 9.

F-Score

Net Income 1

Cash Flow From Operations 1

Change in ROA 0

Quality of Earnings 1

Change in Debt Leverage 1

Change in Current Ratio 1

Change in Shares Outstanding 0

Change in Gross Margin 0

Change in Asset Turnover 0

5

ADDvantage’s F-Score of 5 is mediocre.

Free Cash Flow Margin: 7.45%

ADDvantage’s free cash flow margin is fine. The company’s operating margin is excellent.

And the stability of AEY’s operating margin is mind bogglingly high. Very few companies –

outside of grocery store aisles – have anywhere near the low level of operating margin

variation seen at AEY. The free cash flow margin suffers from constant inventory growth.

This changed in the last 2 years.

Operating Margin Free Cash Flow Margin

2010 15.97% 21.14%

2009 13.65% 13.44%

2008 14.97% 1.37%

2007 19.11% 2.00%

2006 15.45% 0.27%

2005 19.84% 11.35%

2004 20.15% 11.38%

2003 18.59% 0.97%

2002 13.93% 6.93%

2001 21.22% 5.62%

Mean 17.29% 7.45%

Standard Deviation 2.65% 6.46%

Variation 0.15 0.87

The cash conversion situation at ADDvantage is similar to the one at Lakeland Industries.

Return on Assets: 22.77%

ADDvantage’s return on assets is excellent. Companies with returns this high – 22.77% pre-



tax translates into 14.80% after-tax – almost always trade for much more than book value.

ADDvantage trades for less than book value.

Return on Assets

2010 16.01%

2009 11.49%

2008 17.84%

2007 31.94%

2006 21.55%

2005 33.36%

2004 31.51%

2003 25.36%

2002 14.99%

2001 23.60%

Mean 22.77%

Standard Deviation 7.35%

Variation 0.32

We will buy ADDvantage Technologies on Monday.

Model Portfolio

Cost Market

Gencor (GENC) $615.23 $540.54

TSR (TSRI) $633.45 $492.00

Lakeland (LAKE) $616.00 $518.70

GTSI (GTSI) $648.96 $544.00

AIR T (AIRT) $661.68 $597.60

Imation (IMN) $629.38 $491.18

OPT-Sciences (OPST) $659.30 $660.00

Micropac (MPAD) $670.00 $650.00

Solitron (SODI) $664.14 $667.44

Cash $701.85

$5,863.31

Transactions 03/07/2011: Bought 77 shares of Gencor (GENC) @ $7.90. Paid $7 commission. Total cost of

$7.99 a share.

04/04/2011: Bought 123 shares of TSR (TSRI) @ $5.09. Paid $7 commission. Total cost of

$5.15 a share.

05/09/2011: Bought 70 shares of Lakeland (LAKE) @ $8.70. Paid $7 commission. Total cost

of $8.80 a share.

06/06/2011: Bought 128 shares of GTSI (GTSI) @ $5.02. Paid $7 commission. Total cost of

$5.07 a share.

07/05/2011: Bought 72 shares of AIR T (AIRT) @ $9.09. Paid $7 commission. Total cost of

$9.19 a share.

08/08/2011: Bought 82 shares of Imation (IMN) @ $7.59. Paid $7 commission. Total cost of

$7.68 a share.

09/08/2011: Bought 55 shares of OPT-Sciences (OPST) @ $11.86. Paid $7 commission. Total

cost of $11.99 a share.



10/13/2011: Bought 130 shares of Micropac (MPAD) @ $5.10. Paid $7 commission. Total

cost of $5.15 a share.

11/07/2011: Bought 206 shares of Solitron Devices (SODI) @ $3.19. Paid $7 commission.

Total cost of $3.22 a share.

Performance March: (1.68%)

April: (0.77%)

May: (2.04%)

June: 0.95%

July: (6.17%)

August: (5.06%)

September: (2.90%)

October: 0.77%

November: (1.61%)

The portfolio’s monthly performance is measured from the publication of one issue of the

newsletter until the publication of the next issue.

Next Issue The next issue will be published at 8 p.m. on Friday, January 6th.

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AEY Report Graham Net Nets Dec 2011

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