Varian

December 2, 2011

BARGAIN BASEMENT STOCK PICKS FROM VALUE GURUS

ADDvantage Technologies (AEY)

INSIDE THIS ISSUE Stock Price Net Current Assets: Tangible Book Value $2.02 $2.56 $3.30

ADDvantage..........Page 1 Portfolio..Page 6

What is a Net Current Asset Bargain?

ADDvantage Technologies (AEY) is an interesting company. Its 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. Heres what you get with every share of ADDvantage you buy:

A net current asset value bargainor net-netis a stock selling for less than the value of its current assets cash, receivables, and inventoryminus all liabilities. Basically, its a stock selling for less than its liquidation value.

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. Its been AEYs 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 AEYs 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 cant be put into inventory growth like it used to. Whats 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

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profitability. ADDvantages streak is longer at 25 straight years of profits. The company hasnt 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 ADDvantages 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. Its been growing up until the last few years. And its 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. Theres no disputing that up until now ADDvantage has achieved much higher returns on capital and fat operating margins through its inventory strategy. Its 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 cant ship old or hard to find inventory. Original equipment manufacturers dont do that. They arent about small, quick, and local. Theyre about centralized and standardized business. They dont 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 ADDvantages business is who these customers are. Why would they order from someone who is obviously more expensive? ADDvantage doesnt claim to sell Ciscos 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 were 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 dont even add up to 25% of sales. But thats looking at things backwards. What really matters is how important ADDvantage is to their customers. ADDvantage does not seek to be any companys sole supplier. And ADDvantage doesnt 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 ADDvantages 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
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be sure they can have the lowest downtime possible. Ultimately, its 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 Ive used Cisco as an example here to help you visualize the product I assume youve seen Scientific-Atlanta products before and not because Cisco literally accounts for almost all of ADDvantages 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. Thats what these regional locations are. ADDvantage ships and repairs from them. Thats why they need to be in different places around the country. Anyway, thats ADDvantages competitive strategy. You can like it or hate it. But it has worked in the past. The companys 10-year average return on invested tangible capital is about 22% pre-tax or more than 14% after-tax. Thats 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 ADDvantages return on assets, margins, etc. in the future. They could be right. The new Cisco deal is clearly a negative. However, Im 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. Theres 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 doesnt serve cable TV. Whether cable companies will be providing fewer triple play internet, TV, and phone services is a different question. And its a hard one to answer. Theres certainly no devastatingly obvious trend in terms of how many cable company products will be in peoples homes. There may be fewer TVs. But will there be less internet? ADDvantage isnt just an asset value bargain. Its a very cheap earning power bargain. To give you some perspective, at the companys 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 ADDvantages 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 youre really saying that ADDvantages business has to deteriorate in a way that more than makes up for the inevitable bounce back in cable
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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. Theyre 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. Well buy shares of AEY on Monday. As always, here are some numbers you might find useful. Vital Signs Z-Score F-Score FCF Margin Pre-Tax Return on Invested Tangible Assets FCF Margin Variation Return on Assets Variation 4.01 5 7.45% 22.77% 0.87 0.32

Z-Score: 4.01 ADDvantages Z-Score and F-Score are adequate. A Z-Score above 3 indicates bankruptcy is unlikely. Z-Score Ratios Working Capital / Total Assets Retained Earnings / Total Assets EBIT / Total Assets Market Cap / Total Liabilities Net Revenues / Total Assets 71.42% 79.38% 14.28% 113.18% 89.40%

Z-Score Calculation Working Capital / Total Assets Retained Earnings / Total Assets EBIT / Total Assets Market Cap / Total Liabilities Net Revenues / Total Assets

Points 0.86 1.11 0.47 0.68 0.89 4.01

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F-Score: 5 The F-Score is a much simpler calculation than the Z-Score. Its 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 Cash Flow From Operations Change in ROA Quality of Earnings Change in Debt Leverage Change in Current Ratio Change in Shares Outstanding Change in Gross Margin Change in Asset Turnover 1 1 0 1 1 1 0 0 0 5 ADDvantages F-Score of 5 is mediocre. Free Cash Flow Margin: 7.45% ADDvantages free cash flow margin is fine. The companys operating margin is excellent. And the stability of AEYs 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 2010 2009 2008 2007 2006 2005 2004 2003 2002 2001 Mean Standard Deviation Variation 15.97% 13.65% 14.97% 19.11% 15.45% 19.84% 20.15% 18.59% 13.93% 21.22% 17.29% 2.65% 0.15 Free Cash Flow Margin 21.14% 13.44% 1.37% 2.00% 0.27% 11.35% 11.38% 0.97% 6.93% 5.62% 7.45% 6.46% 0.87

The cash conversion situation at ADDvantage is similar to the one at Lakeland Industries. Return on Assets: 22.77% ADDvantages return on assets is excellent. Companies with returns this high 22.77% pre Copyright 2011 by Gurufocus.com, LLC 5

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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 2009 2008 2007 2006 2005 2004 2003 2002 2001 Mean Standard Deviation Variation We will buy ADDvantage Technologies on Monday. 16.01% 11.49% 17.84% 31.94% 21.55% 33.36% 31.51% 25.36% 14.99% 23.60% 22.77% 7.35% 0.32

Model Portfolio
Gencor (GENC) TSR (TSRI) Lakeland (LAKE) GTSI (GTSI) AIR T (AIRT) Imation (IMN) OPT-Sciences (OPST) Micropac (MPAD) Solitron (SODI) Cash Cost $615.23 $633.45 $616.00 $648.96 $661.68 $629.38 $659.30 $670.00 $664.14 Market $540.54 $492.00 $518.70 $544.00 $597.60 $491.18 $660.00 $650.00 $667.44 $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.
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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 portfolios monthly performance is measured from the publication of one issue of the newsletter until the publication of the next issue.

Next Issue
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