TECH DATA CORP TECD
March 22, 2018 - 1:51pm EST by
singletrack
2018 2019
Price: 84.00 EPS 10.25 10.70
Shares Out. (in M): 39 P/E 8 8
Market Cap (in $M): 3,250 P/FCF 8 8
Net Debt (in $M): -600 EBIT 650 675
TEV ($): 2,650 TEV/EBIT 4 4

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Description

Thesis / Summary: Tech Data is an orphan of the tech world.  A boring distributor, that at first glance, has minimal revenue growth, thin margins, no technology advantage or IP, appears to just ship hardware, and the common opinion is that all distribution businesses will eventually be extinguished by Amazon.  I’ve followed TECD (and Ingram Micro) for eight years and fellow investors generally have no interest in hearing about these stocks. 

But, TECD is actually a good company and is trading for 8x EPS with a good balance sheet, and has grown EPS at a 12% CAGR over the past 15 years.  Don’t think of them as a competitor in the tech supply chain – think of them as a middle-man or partner.  Tech Data is the second largest end-to-end IT distributor in the world, connecting over 1,000 suppliers offering hundreds of thousands of products to a broad base of over 115k customers in the form of value-add resellers (VAR’s).  Tech Data provides an indispensable link between vendors and customers. From the vendor perspective, they act as an outsourced, variable cost salesforce, charging a percentage-based commission on sold product. This variable cost relationship allows tech vendors working with the distributor to avoid both building out high fixed cost internal salesforces and replicating the more than 100k customer relationships that Tech Data manages. As a trusted advisor to its customers, Tech Data also serves a marketing function for vendors by making product recommendations.  One former employee, who I spoke with, described himself as a lobbyist for vendors.  “I was a partner of those companies, not just working for a distributor…someone told me once I was a lobbyist – that’s exactly right. I had to know the products well enough and had to build programs and marketing plans to understand how to sell the Microsoft and then the HP product.” 

From the customer perspective, TECD offers the benefits of scale, financing, inventory management, and expertise. Tech Data has massive purchasing scale that it leverages to provide discounts to its customers. Approximately 75% of these customers are small and medium businesses that lean on Tech Data for financing. Tech Data’s just-in-time delivery of its products allows these customers to operate functionally with minimal balance sheet inventory. And, as described above, the company provides its customers with expertise they sometimes lack and will help to educate about new programs or products.  Interestingly, if you are a value-added-reseller, one offering that TECD provides is an employee for-hire. It’s actually a SKU.  If a value-added-reseller is working on an IT installation project and needs additional help or consulting, you can hire a TECD employee (at an hourly rate), who will wear your uniform and appear to be part of your team.  It’s this type of service business and expertise that distinguishes TECD from the pure distribution model you might imagine.  Plus, one common concern is that the value-added-resellers could disintermediate TECD from the supply chain, but CDW (the largest VAR) actually is one of TECD’s largest customers.

Despite the vacuum of interest around this stock, the financials support my qualitative argument that TECD is a good business. 

  • EPS – From 2003 through 2018E, TECD has grown EPS from ~$2 to over $10 (12% per year).  The stock currently trades for $85 or near 8x EPS – the same multiple it had during the financial crisis in 2008!  And, unlike most other tech companies, TECD actually includes stock-comp as an expense, which is about $0.50 per share. 
  • ROIC – over the past 10 years, TECD has averaged a 14% return on tangible capital, which I think is the key evidence of the business quality.  More impressive is that from 2007-2010, during the financial crisis, TECD grew EPS from ~$2.50 to ~$4.50 and maintained a double-digit ROTIC.
  • Revenues adjusted for FX – TECD has nearly 50% of its revenue in Europe.  At first glance, it looks like sales declined by low single digits in both 2015 and 2016, causing reason for concern.  But, the euro had a large impact and adjusting for currency, TECD has been able to grow sales by low-to-mid single digits y/y historically.  
  • Margins – some folks balk at TECD because its operating margins are about 1.5%.  But, I view that as a misleading figure.  Think about how the business works – TECD effectively earns a “commission” for selling a product, but books the whole cost of the product as revenue.  If it just booked the “commission” (or its gross profit) as revenue, then operating margins would be closer to 25%.  There’s no economic difference between the two margins, but I suspect folks would think of this of a higher quality business if it had those higher margins. 
  • Capital Allocation – part of the reason TECD has been able to generate double-digit EPS growth is because of its strong capital allocation.  Shares outstanding have fallen from 52m in 2009 to 35m in 2016 (before issuing 3m as part of the Avnet deal).  Now, only 12 months after the Avnet deal closed, they were able to return to their target debt level and can resume share repurchases. 
  • Inventory and Return Rights – a majority of the company’s capital is made up of its inventory.  Another worry people have is that because technology evolves so fast, TECD must often get stuck with obsolete inventory.  But, remember to think of them as partners, not customers, of the vendors.  On paper, a majority of the inventory is protected by return rights from the vendors, and in practice nearly all of their inventory can be put back to the vendors if it doesn’t sell.  As one former employee said: “Once distribution buys, it is theirs – they own it.  TECD gets about 7c on the dollar if they need to liquidate.  But, 10 times out of 10, the vendor will help them with rebates…deep down you knew you needed each other, so you wouldn’t screw the other person over”. 
  •  Management Compensation – paid on ROIC, EPS, and regional profit for certain executives. 

AmazonWhile Amazon presents a threat to many companies in the distribution space, Tech Data is not likely to be one of them. Amazon’s business model relies on quickly getting customers the products they know they want at cheap prices. By contrast, Tech Data’s business model focuses on leveraging its 14k employees to provide education and support to customers that are installing complex systems. As one industry participant stated: “No, I do not think Amazon is a threat” If we’re talking simple product, Amazon will chip in (with a computer or tablet).  But, what do you do when you get the product?  You have to install the software and integrate to other hardware – so unless Amazon hires and builds 2,000 system engineers, they will not be able to compete.” 

Software – Another fear around TECD is that they will lose importance as the industry moves towards the cloud and away from hardware purchases.  First, TECD is still involved with software as they get a fee for integrated software onto hardware that they dispense.  For example, if you purchase a server with a firewall program, an operating system, and virtualization software, TECD will actually integrate those different products for you.  Plus, some folks forget that with the cloud there is always hardware installed at some location, even if it is offsite for the end user.     

Avnet Deal – In late 2016, TECD announced the acquisition of Avnet’s enterprise business which added a similar, but more specialized, higher margin enterprise business.  This was a good deal for them on different fronts.  It increased their exposure to data centers, which tend to have more project-based work and should be a beneficiary of a move towards cloud-based growth.  The broader purpose of the deal also makes real sense, and it is so that “solution providers can fulfill all of their product and service needs in a single place” (TECD CEO). It also adds depth on the higher touch and higher complexity end of the distribution business. Avnet’s business ran with much less inventory and generated OM’s near 3.5% vs TECD at 1.4% as it provides more specialized project management solutions. While TECD does 50k transactions per day, TS does only 1k.  As TECD’s CFO has said: “it’s a move toward higher value from a business model perspective…the value segment of the market has better financial attributes than the volume segment.”

From a financial perspective, TECD was under-levered with Net Cash to EBITDA of 1x prior to the Avnet deal.  That increased to 2x Net Debt after the deal and has subsequently been brought back down to below 1x, so they can resume share buybacks (at 8x EPS!).  Because they were so under-levered, the accretion on this deal was massive with next-year EPS expected to be over $10.50, up from under $6.50 in 2016. 

4Q17 Earnings – the stock sold off nearly 20% after its earnings announcement in early March.  4Q Sales and EPS actually came in better than expected, but the 1Q forecast was below expectations and they tweaked their full-year operating profit estimate down.  Interestingly, the implied EPS for next year went up because of a lower tax rate to ~$10.85 (from $10.60 that they expected for next year as of their Investor Day in October 2017).  There were some concerns about vendor pressure, but we believe this is part of their normal business operations and sometimes result in volatile earnings over the short-term.  As the CEO said on the call: “it’s been like that forever. This isn’t a unique moment in time. It’s just the way the [distribution] channel and the direct [salesforce] works together”.   Plus, they achieved their target debt-level 6-12 months ahead of plan and can now commence returning capital to shareholders through stock repurchases. 

Valuation and Forward Earnings – for the year-ending January 2019, TECD First-Call EPS is $10.50.  We prefer to look at 5-year forward earnings and apply a 9x P/E multiple. We think they can grow EPS 10% sustainably.  That would result in 5-year forward earnings of $17.50 and a fair value of ~$160.  This would equate to roughly 15x next-12-months EPS, which I think is reasonable in today’s market. 

Risks –

  • Vendors move to a more direct-sales model.
  • Avnet integration goes poorly.
  • TECD is unable to integrate its Avnet acquisition. 

 

 

 

I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise hold a material investment in the issuer's securities.

Catalyst

Earnings reports and stock repurchases.  

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