April 23, 2010 - 10:59am EST by
2010 2011
Price: 18.40 EPS $1.80 $2.00
Shares Out. (in M): 165 P/E 10.0x 9.0x
Market Cap (in $M): 3,030 P/FCF 10.0x 9.0x
Net Debt (in $M): 530 EBIT 450 500
TEV (in $M): 2,500 TEV/EBIT 5.5x 5.0x

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I believe an investment in Ingram Micro represents an asymmetric risk/reward opportunity.  The company trades at 1x tangible book value, 5.5x estimated 2010 EBIT and 5.0x estimated 2011 EBIT - well below historical averages and any reasonable assessment of fair value.  I think upside is likely around 50% over the next year and downside appears extremely low given the company holds almost 20% of its market cap in net cash, trades at less than 90% of forward tangible book value (which consists mainly of cash and high quality receivables and inventory) and has a stable, leading market position.

Ingram Micro is the largest wholesale distributor of technology products in the world, selling around $30 billion of products worldwide.  From September 2008 to September 2009, Ingram Micro saw its revenues decrease by 18% as worldwide demand for technology products declined sharply.  The company maintained solid profitability through the downturn and turned its focus to rationalizing its workforce and reducing costs to better align the business with the lower demand levels. 

I believe that last year's downturn is likely to sharply reverse as a result of significant pent-up demand and a strong PC upgrade cycle (which is already happening broadly across many companies in the technology universe).  Ingram Micro's operating profits are likely to increase from approximately $320 million in 2009 to at least $450 million this year and possibly over $500 million under a normal demand environment given an improved top line and a lower cost structure. 

There are several factors restraining Ingram Micro's valuation: 

(1) a view that low operating margins present significant operating risk

Ingram Micro's reported operating margins of 1.0% to 1.5% are deceptively low.  The company takes around a 5% to 6% mark-up on products that it resells but it records the full gross sales price as revenues.  Given that around 95% of the sales are purely variable costs, I consider the operating profit as a percent of the gross profit as a more accurate reflection of the business's operating margin - this number is closer to 20% and has not fluctuated significantly over time. 

To support my view that the true operating margin is higher (and hence the operating risk is lower), I would point out that Ingram Micro has never had an unprofitable quarter in its history as a public company - a period that includes the most recent financial crisis and the technology downturn of 2000 to 2002.    In 2009, the true operating margin only declined from 22% to 20% despite a double digit decline in sales.

(2) a lack of appreciation of the margin of safety provided by the balance sheet

Perhaps what I like most about Ingram Micro is the margin of safety provided by a highly liquid balance sheet and a stock valuation right around its tangible book value.  Ingram Micro's balance sheet consists of approximately $530 million of net cash and $2 billion of working capital.  The working capital consists of receivables and inventory, both of which turn over every 30 to 40 days and are therefore highly liquid and readily valuable.  The company has never had material credit losses and inventory is generally protected from any price cuts by its suppliers. 

(3) the soft top-line results of the past year

Recent evidence pertaining to technology spend indicates a very strong rebound off of the depressed levels of 2009.  As a result, I believe the soft top line results of 2009 should dramatically reverse allowing the company to register double digit top-line growth and margin expansion. 

(4) a view that fairly low returns on equity demand a low valuation 

Ingram Micro's return on equity has historically averaged around 10%.  While this is a respectable level, it is well below the levels to which technology investors are accustomed, and it has therefore negatively impacted the stock's valuation.  However, this figure significantly understates the attractiveness of Ingram Micro's business.  The company has historically operated with virtually no net debt and has more recently held a sizeable cash balance.  The company's pre-tax return on capital has averaged over 15% but return on equity has been weighed down heavily by its conservative capital structure.  To highlight this point, if the company utilized a 50% debt / total capitalization ratio, I estimate return on equity would increase to a very attractive level of approximately 17%.  Given the historical stability of the operating cash flows and the highly liquid nature of the company's assets, such a capitalization level could still be arguably conservative.

Actually, I would argue that almost the entire market capitalization of Ingram could be sitting in excess capital.  I don't think it would be inconceivable for the company to operate with debt to capitalization levels closer to 80% to 90% - much like a financial company.  Its assets are better credit quality than your average bank and the return on assets are higher and more consistent.  While the company is certainly not going to lever to this level, it highlights the attractiveness of this asset to a financial buyer and demonstrates the level over overcapitalization/safety at Ingram. 

I believe there are several possible outcomes for an investment in Ingram Micro: 

(1) the company will productively deploy its cash balance in buybacks or acquisitions as it has in the past resulting in a higher return on equity and a higher stock valuation;

(2) the stock will appreciate as the negativity around soft demand reverses and the market discounts the cash flows to the equity holders at an appropriately low discount rate (reflecting their unusually low risk), resulting in a multiple above tangible book value; or

(3) the company will be acquired - this would be a particularly attractive asset to a private equity firm. 

I believe a target valuation in line with historical levels (8x operating profit and 1.3x tangible book value) is reasonable, if not conservative.  This multiple would also be at a discount to the current multiples in the pharmaceutical distribution businesses (such as MCK, ABC and CAH) - which I believe is a relevant comparison as they have a fairly similar business model.

My target would place the stock at approximately $27 per share one year from now, which is roughly 50% above the recent price.  These potential returns are particularly attractive given the low risk provided by the company's conservative capital structure.



 Upswing in demand, possible buybacks, return to normal valuation, potential buyout

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