|Shares Out. (in M):||4||P/E||11.4||9.5|
|Market Cap (in $M):||102||P/FCF||11.1||9.3|
|Net Debt (in $M):||-34||EBIT||11||14|
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"Wayside" has been an uncomfortably accurate identity for years, but growth and ROIC are accelerating under new management. The stock is still under 8x our estimate of 2020 EPS net of expected cash, even after breaking out to the upside from a long trading range.
(Due to a change in revenue recognition forced by ASC 606, we use Wayside's "adjusted gross billings" metric in place of reported revenue from 2018 onward.)
With its products delivered almost entirely via Internet downloads, Wayside isn't a distributor of physical goods the way Fastenal or Sysco is. Though its technological infrastructure and back office are important, we think the company is best understood as (1) an outsourced sales and marketing organization for its vendors and (2) a supply-chain organizer and talent scout for its value-added reseller (VAR) customers.
On the first point, Wayside is at its best when it represents software startups that have novel and powerful solutions but limited resources with which to build a national sales effort or command the attention of major VARs. On the second, well-regarded CDW has long been Wayside's largest customer. Why would a huge VAR like CDW pay Wayside a "commission" of sorts year after year if Wayside weren't adding value? It's our understanding that CDW and other major VARs maintain direct relationships with only their highest-volume vendors, leaving a long-tailed but still enormous opportunity for a focused distributor like Wayside to help develop and manage supply chains.
We believe the company's role and its ROIC (a value-creating 22% in 2019 even before the substantial improvements we describe below) reflect modest but persistent network effects that reduce search costs for customers and vendors. Middlemen are often in a tenuous position, but if Wayside is going to be disintermediated out of existence, it seems to us it would have happened already. Its oldest predecessor dates to the mid-1970s, and the disruptive potential of the Internet and the squeezing out of middlemen everywhere are hardly new phenomena. Tiny though it is, Wayside's share of North American software industry sales as measured by IDC has still grown slightly over time, to 0.18% in 2019 from 0.15% in 2006.
In addition to Climb Channel Solutions, Wayside has a small VAR of its own (TechXtend) which sells directly to end customers, mainly in the company's New Jersey backyard. In 2004, this unit accounted for a majority of Wayside's gross profit; by 2019, its contribution was just 11%. TechXtend's only competitive angle seems to have been extended payment terms, most of which are being phased out. We view TechXtend as a noncore business that could be sold, transformed, or (as we assume for modeling purposes) merely run in a stable state to generate cash.
Under New Management
There's not much obvious appeal in Wayside's long-term record: rising sales, yes, but falling margins, negligible profit growth, swelling investment in working capital, and deteriorating ROICs. For outside investors there was a hefty dividend, some share repurchases, a healthy balance sheet, and a low P/E, but not much else. Why should anything change from here?
While ever mindful of Warren Buffett's take on the subject at hand ("When a management with a reputation for brilliance tackles a business with a reputation for poor fundamental economics, it is the reputation of the business that remains intact"), we contend that Wayside's record from 2012 to 2018 mainly reflects weak management.
Under the leadership of former CEO Simon Nynens, Wayside seemed content to coast on the industry growth that fell into its lap during much of the last decade. Shrinking gross margins are nothing new or necessarily problematic, but the growth of gross profit dollars slowed and eventually dipped into negative territory in 2017 and 2018. Meanwhile, cash SG&A costs rose faster than gross profit each year from 2014 to 2018, and the conversion of gross profit dollars into EBITDA (what the current management team calls "effective margin") dropped from 37% to 27% in this stretch.
In addition, it may be that Wayside was deliberately hiding cash through inefficient management of working capital. At the time, inflated receivables, inventories, and prepayments seemed like a reasonable effort to earn a higher rate of interest than could be had on excess cash balances in the bank--provide longer terms to customers and shorter terms to vendors in exchange for a slightly higher markup. If that was the idea, it didn't work all that well, as gross margins continued to decline in a linear fashion from 2013 on. But if instead the idea was to dodge activist investors or unwanted takeovers, it worked well. Wayside's balance sheets, though still strong, showed a lot less cash than they might have. ROIC, though still decent, was artificially depressed, obfuscating the true economics of the business.
We can only infer so much from the sequence of events described in public statements, but here’s what happened. Wayside hired a new vice president of distribution (Dale Foster) in January 2018, just before a new director (Jeff Geygan, a value-oriented portfolio manager and large shareholder) joined the board in March. Nynens--who owned 6% of Wayside's stock personally--left the company without warning in May. The only director with relevant industry experience at the time, Steve DeWindt, was appointed interim CEO upon Nynens' departure, and then permanent CEO in October. He left citing health reasons in June 2019. In January 2020, Foster was named permanent CEO.
Such turnover can be off-putting, but we have no doubt that Foster is the right person to run Wayside. He's run exactly the same business before, only with rather more success. Foster became head of Promark Technology, a software distribution business all but identical to Wayside's, in 1997 when its annual sales were $40 million. By the time Promark sold to Ingram Micro in 2012, its annual sales were running at $150 million. Left by the much larger Ingram to continue running Promark as it had been, Foster and his team ran out their five-year noncompete agreements by nearly quadrupling sales to $550 million. By way of comparison, Wayside's revenue was twice that of Promark in 2012. By 2017, Wayside’s sales had grown only 51%, and was roughly 20% smaller than Promark.
Foster didn't come alone, either. In what was described as a new investment in a field salesforce, the key players on Foster's team at Promark joined Wayside as well--including Charles Bass, who is responsible for developing new vendor relationships, the most important source of future revenue growth. Just as important, the board has been almost completely replaced and upgraded since Geygan and Foster arrived. Only one of the seven directors standing at the upcoming board election has been on the board longer than Geygan's two years.
Former CEO Nynens didn't seem too happy about this handoff. As reported in later filings, he partnered with a private equity shop in an attempt to take the company private. The group offered $14.37 a share in June 2019 and then $16.38 a share in August; the latter offer was made public in November. Wayside's board rejected both offers, and the group countered with a proxy fight. For all we know, $16.38 a share may be all Wayside was worth…with Nynens running the business. With Geygan and Foster in charge, we believe Wayside is worth multiples of those bids.
Turnaround Proof Points
We contend that Wayside is a small but growing business that has been mismanaged until recently, that the new management team is already turning things around, and that the stock price has only just started to reflect the company’s potential. But it’s not all that hard to anticipate objections, starting with the downtrend in gross margin despite healthy sales growth.
Our view is that downtrend in gross margin is a predictable and relatively harmless effect of rapidly rising labor productivity as software industry sales rise at 2-3x nominal GDP. Wayside's sales per employee have risen much faster than SG&A per employee (Exhibit 2). While most of the benefit has been passed back to customers and vendors by way of smaller gross margins, gross profit dollars continued to grow through most of this period (Exhibit 3).
We expect Wayside's gross margin to continue shrinking over time, albeit at a slower pace. Emerging vendors with low initial sales volume provide distributors with more generous gross margins than established, high-volume ones. Because Wayside largely failed to develop new vendor relationships in the past few years, the company has to live (for now) with a base of vendors that have disproportionately "gone big" and pay lower markups as a result. If the company's current strategy bears the fruit we expect, a higher proportion of sales from emerging vendors will reduce the rate of gross margin attrition. As it is, initiatives under Foster have already accelerated gross profit dollar growth to an eight-year high on a trailing 12-month basis.
We agree with management that Wayside's key performance indicators are (1) growth in gross profit dollars--think in terms of commission revenue, with a shrinking clip on rapidly swelling volume--and (2) effective margin, or the conversion of gross profit dollars into EBITDA. On both counts we find expanding evidence not just of accelerated sales success, but also of cost control and improved productivity--owing much to our perception of "flabbiness" under previous management. We note that in the first quarter of 2020, gross profit rose 13% year over year, while SG&A was down 0.3%.
Finally, we believe ROIC is about to skyrocket. As recently as early 2008, invested capital --almost all of which is net working capital--was close to zero. This produced ROICs that were literally off the chart (Exhibit 5). In the past three years, however, invested capital averaged $31.3 million. This growth of working capital nearly faked us out early during our research: If working capital grew as fast as sales but gross margin continued to decline, ROIC and shareholder returns would suffer as well.
Instead, whatever the motivation of previous leadership, the enlargement of invested capital and the diminution of ROIC appears to have been a strategic choice--and that choice is being reversed. The hint is found in the "Liquidity and Capital Resources" section of the first-quarter 10-Q filing, rather than the most recently published balance sheet.
"During the second quarter of 2020, we expect to implement a change in the payment terms with one of our large customers. The impact of this change in payment terms is expected to result in a reduction of our accounts receivable and corresponding increase in cash of approximately $25 million during the second quarter of 2020. This change in terms will also have the impact of reducing our net sales and gross profit by approximately $0.4 million per quarter, however, we believe the additional liquidity will improve our return on invested capital and provide us greater flexibility in pursuing our strategic objectives."
We assume "one of our large customers" is CDW. Under a worst-case scenario--in which Wayside absorbs the full $0.4 million/quarter hit to gross profits going forward, and that within the broader trend of shrinking gross margins--we still find that invested capital shrinks 75%, while aftertax profits drop only 16%. Our pro-forma estimate of ROIC rockets to 65%. To liberate $25 million at the cost of $1.2 million after taxes implies this capital was earning a mere 4.8% return, well below what we think Wayside can earn under management's new strategy.
More important, this change validates our view that Wayside is a service business, with its value proposition derived from the productivity of its sales team and its vendor-recruitment efforts--in other words, matching sellers with buyers--than from supplying working capital to both sides at a low rate of return.
A $1.6 million hit to annualized gross profit is no small pill for Wayside to swallow, but our conversations with management lead us to believe the impact will be short-lived. Wayside had to give something up in the short term to extricate itself from the badly negotiated deals of the past; the good news is that contracts to supply value-added resellers are renewed at 4- to 6-month intervals. If we're correct, and Wayside was "hiding cash" by way of uncompetitive payment terms, then ultimately the company has nothing to lose. Moreover, we note that CEO Foster's incentive compensation package is based on gross profit growth and EBIT growth--not ROIC as such. We doubt he would take a 16% permanent hit to gross profit (and an even larger decline in EBIT) without (1) a very good line of sight to recovering the loss and (2) a very good plan to redeploy the freed-up cash.
With a variety of interesting developments at midyear, we find it helpful to describe Wayside's earnings potential on an annual run-rate basis. (We think actual results will likely land in a similar area, excluding one-off items such as those recorded in Q1.)
In the walk from 2019 to 2020, we identify an unusually high level of vendor rebates and early-pay discounts that were called out in the second quarter of 2020, and $100,000 of separation expenses in the same quarter when former CEO DeWindt left. This gives us a normalized base for 2019 EPS of $1.46 (GAAP of $1.51).
For 2020, before capital actions described later, we assume:
Together, these "ordinary" considerations provide us with $0.50 of incremental EPS, lifting Wayside to $1.96 from last year's normalized $1.46. Then:
We assume that the $1.6 million initial annualized loss in gross profit from renegotiating contracts with CDW will eventually be cut in half to $0.8 million through future contract renewals. We reflect this effect with a $0.14 a share hit in our 2020 estimate relative to our take on normalized 2019 EPS. That said, with CEO Foster's incentives in mind, we would not be surprised if all of the lost gross profit is recovered within a year.
We expect lower interest income in 2020, owing mainly to how Wayside has been booking interest income. When Wayside extends long payment terms to customers (particularly in the TechXtend segment), it books a portion of the markup on the sale as interest income rather than gross profit, and this treatment accounts for the bulk of Wayside's interest income in the last couple of years. Under Foster's management, Wayside has been running down its long-term receivables book rather quickly as it represents an ineffective use of capital, so interest income necessarily drops as well (while ROIC excluding cash rises). This represents a $0.05 headwind to our 2020 estimate from 2019's showing.
In its first-ever acquisition as a public company, Wayside bought Interwork Technologies in a deal that closed at the end of April for C$5 million plus up to C$1.1 million of earnouts. (In U.S. dollars, that's $3.6 million plus $0.8 million at today's exchange rate for the full earnout, or about $4.5 million in total.) While Interwork's full financials have not been disclosed, Wayside guided publicly to $1 million of EBITDA from the acquisition once synergies are realized. It seems to us that the synergies won't be at all hard to extract: Interwork had its own vendor base, its own VAR customer base, and a gross margin not too different from Wayside's, but it didn't have the scale to leverage gross profit dollars against its back-office expenses. Once integrated, Wayside should be able to all but zero out Interwork's back-office and corporate costs, easily realizing the $1 million of expected run-rate EBITDA that Wayside guided to on its first-quarter earnings call.
We also understand that Interwork's net working capital position is close to zero, which adds weight to our view that Wayside's poor ROIC in recent years was a matter of choice rather than fate. But in this transaction, Interwork (focused mainly on Canada and thus integrated with Wayside's existing salesforce) will soon be able to represent Wayside's entire vendor catalog to its customers, while Wayside has picked up several new vendors that it should be able to represent to its U.S. vendor base.
As roll-ups go, this one strikes us as having unusually compelling economics. For the purposes of our current "run-rate" EPS estimate, we add $1 million of annualized pretax income ($0.17 a share). For GAAP purposes, there will probably be some intangible amortization arising from this transaction and others to follow; we can't estimate it now, but we don't expect management or investors to pay much attention.
Wayside has 6% fewer shares outstanding today than it did on March 31. In mid-April, former CEO Nynens and his private equity backers agreed to stand down, settle all litigation (which cost Wayside $1.3 million pretax), and have Wayside repurchase the 261,361 shares Nynens owned at what was reported in the first-quarter 10-Q to be $13.19 a share. With little aftertax interest income sacrificed in the trade at current interest rates, the buyback lifts our 2020 earnings estimate by another $0.13 over our take on normalized 2019 EPS.
The foregoing change factors from 2019 bring us to 2020 EPS of $2.07, up 42% from our view of normalized 2019 results. But when we can, we like to have more than one angle on earnings estimates. Consider first-quarter 2020 adjusted EPS of $0.48--Wayside's second-highest quarterly result ever, even though the period is the seasonally weakest quarter. Going back to 2006, we identify a fairly consistent 22% of median annual profits being recorded in the first quarter (the fourth quarter is the typical bell-ringer at 31%). From that we imply that $0.48 in the first quarter indicates $2.18 in annualized EPS even before the net beneficial effects described in Exhibit 6 (that is, $0.48 divided by 0.22).
As for cash, we start with the $11.6 million shown on the March 31 balance sheet. Since then, Wayside has laid out $3.6 million to acquire Interwork and $3.5 million to repurchase Nynens' shares. But before the end of June, we expect Wayside to receive (1) $3.4 million on a receivables arrangement from a specific VAR that was temporarily deferred into the second quarter because of pandemic difficulties; (2) $25 million from the change in terms with CDW, and (3) roughly $2 million of free cash flow in the second quarter excluding the two receivables items already noted, less (4) $732,000 worth of dividend payments in the second quarter. While we don't have any specific estimate as to how other working capital movements might figure into this analysis, the foregoing nets out to about $34 million of cash at June 30, or $7.95 a share.
With the stock at $23.65 on 6/12/2020, or $15.70 after our estimated cash position at the end of Q2, our run-rate EPS estimate of $2.07 indicates an ex-cash P/E of 7.6x. The same stock price also translates to an enterprise value of $67.6 million, only 5.7x our run-rate EBITDA estimate of $11.8 million. With the unwinding of excess working capital, we expect free cash flow to approximate net income post-2020, placing the stock at a forward FCF yield of 14% (again excluding our forecast for net cash).
These metrics suggest the stock is cheap in an absolute sense--and much more if Wayside is in the process of demonstrating its high-ROIC, high-FCF conversion nature … in an industry that is growing ~10% a year … in which the company is gaining share quickly off a miniscule base. So: How high could it go?
Since 2006 Wayside's ex-cash P/E has ranged from 16 to as little as 1 (in the depths of the Great Recession; Wayside was last pitched on VIC in May 2009), with a median of 9x. At that median, given our run-rate EPS view of $2.07 and $7.95 a share in net cash, Wayside should trade at $26.58--making the stock somewhat underpriced here, but not massively so. Upside might seem constrained too by the generally modest valuations of fellow members of the GICS Technology Distributors sub-industry, such as Arrow Electronics (9.3x TTM EPS according to Bloomberg) and Synnex (9.2x).
But with Wayside's financial performance breaking out to the upside--particularly with its ROIC about to soar on reduced working capital--we believe it should trade at least at the high end of its historical range. The growth in gross profit dollars and EPS that we anticipate, along much-improved ROIC and FCF conversion, closely resemble the company’s performance in 2006 and 2007 when the stock traded at 15x net of cash. That multiple, which we note is still a 1/3 discount to the S&P, yields a current fair value of $39.07 ($2.07 EPS multiplied by 15 plus $7.95 in net cash).
Furthermore, we don't think 2020 is anything close to the end of the story. Assuming the Climb segment generates internal gross profit growth of 15% a year with a 50% contribution margin, we see EPS rising to $2.48 in 2021 and $2.95 in 2022. We expect Wayside to convert roughly 100% of these earnings to free cash flow, allowing it to accumulate another $4 per share of net cash by year-end 2022 after dividends at the current rate. Even with no multiple expansion from here, the stock is worth $34 in two and a half years (a 19% internal rate of return including dividends). At 15x, the stock hits $56 (43% IRR).
Rather than seeing cash accumulate, though, we view the Interwork transaction as a template for additional bolt-on deals that should be highly accretive. On the low end, we assume Wayside deploys only $15 million by 2022 at an average EBIT multiple of 7; that reduces net cash by about $3.50 a share but adds $0.39 a share to earnings. At the high end, $30 million in bolt-ons at the same 4.5x post-synergies multiple as Interwork would cost $7 a share in net cash but boost EPS by $1.20. Given our underlying internal growth scenario ($2.95 in 2022 EPS), our high-end outlook could see 2022 run-rate EPS of $4.15 plus $5 a share in remaining net cash. At a 15x, the stock stands to be worth $67.
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