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Author: WTilson One star, 50 posts Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 5655  
Subject: EMs with Dale Date: 4/8/1999 12:23 PM
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Recommendations: 2
Hi,

I'm looking hard at APCC and have been exchanging some emails with Dale that I thought you might be interested in:

Dale,

I took another hard look at APCC and I'm rethinking what I wrote you on 2/28:

Did you see AAPC made the WSJ's list last week (Thurday's Shareholder Scoreboard) of one of the best performing stocks over the past 10 years (up 65.6% compounded, #3, trailing only Dell and EMC--WOW!)? I just took another look and saw the stock's been crushed since the co. announced earnings on 2/4. They looked pretty solid. What happened? The patent infringment lawsuit? Regardless, I have some real questions: 1) the flow (current assets minus cash, divided by current liabilities minus short term debt—the Fool's favorite quick tool for gauging balance sheet strength) of 2.51 is awful and getting worse (up from 2.38 in Q4 97 and 2.10 in Q3 98); 2) net margins for the year declined from 14.0% to 13.1%; 3) I'm not sure that I will ever come to believe that this company has a powerful, sustainable competitive advantage (though you wrote that they blew HP out of the water--an impressive feat). Too bad--when I ordered my new Dell laptop last week, I saw that APCC products were the only add-ons Dell sold. Also, this company generates excellent returns on invested capital (over the past 5 years, 2.5x the cost of capital, according to the Stern Stewart 1000).

I'm now more persuaded about APC's competitive advantages--it's not a huge moat, but it's a solid one. Also, I like the price a lot more at <20x earnings. And I hear your argument for the need for high inventory levels, but I'm still very concerned about the level and the direction. From the 10K, finished goods inventory went from $39M to $131M in one year! Your explanations sound reasonable, but consider this:

I just did an analysis of APCC's flow ratio each quarter back to Q4 94 and there's a remarkable correllation between the flow (and its direction) and APCC's share price. Here's the data:

Q1 Q2 Q3 Q4
94 3.37
95 2.80 3.74 4.34 4.61
96 4.23 3.62 2.42 2.56
97 2.56 3.16 2.60 2.37
98 2.02 2.03 2.10 2.51

Now, let's look at the share price over this period. In the 2nd half of 1995, when the flow soared, the stock was down 40% or so. In the second half of 96, as the flow plunged, the stock soared 150%. As the flow went up a bit in the first half of 97, the stock dropped 30% or so. Then, the flow dropped again in the first three quarters on 98 and the stock was up 100%. Finally, the flow jumped in Q4 98 and the stock is off 40% this year. Coincidence? I think not.

So, I'm going to wait until the next quarterly earnings come out in a month to see what happens. This may cost me some money--esp. with yesterday's 9%+ jump, but I have to be certain on this.
---------
Whitney,
In the second half of calendar 95, they had a component problem and had to
work over a lot of finished goods. That pushed up finished goods rapidly and
then they worked it down. But that's the cycle you see from Q1-end 95
through Q1 96. Undoubtedly, value is dependent on cash flow. The latest flow
ratio numbers are to be expected. I think there is a little inventory
backup, but they're building a global company. You have to like building
plants in China and India. I've just accepted that this is a high flow ratio
business. That's a weapon they use and I think they cover costs on
inventory, especially since it doesn't depreciate rapidly. One of the
reasons inventory is high is because these suckers are expensive to ship. A
big UPS with a huge battery in it is very heavy. After all, that's a big
hunk of lead in there.

Here's the model I'm working on. I'm still building out the valuation
section. It's obvious that the market is discounting the working capital
cash flow needs, because if you just discount a bunch of earnings ignoring
those things, it looks like it's worth a lot more. The scenarios in the
valuation models are a little conservative, but better to do it that way. If
it can manage down its inventories a bit from here, to 105 days, and keep it
there, it's a fine value. On a discounted earnings basis, it's worth in the
mid-$30s on a conservative basis. The earnings from here should be clean, as
I except this is the top of the current assets range they work with.

Anyway, here's the spreadsheet.
Dale
---------
Dale,
I agree 100% that this is a high inventory business and that a high flow ratio is therefore normal and to be expected. Historically, APC has kicked butt when the flow is 2.0-2.5; when its gone above this, the stock has suffered, as a high flow ratio has reflected problems that you outlined (components in 1995; I wonder what happened in Q2 97?).

I think the jump in inventory (and thus the jump in the flow ratio) is causing the market (myself included) to wonder whether this is a blip (as you believe) such as Q2 97 (which was an excellent buying opportunity), or the start of an even bigger problem, portending greater hits to the stock. For example, when the flow jumped in Q2 95, the stock dropped 50% right around the time that the Q2 earnings were announced. But those who jumped in, seeing this as a blip, lost more than 40% (based on the lower base price, not the peak) through the end of the year.

Suffice it to say, I'll be watching inventories and the flow ratio closely in the next earnings announcement. If they drop, I'm a buyer (assuming the stock doesn't run up too much by then)…

I liked your model. If you're right that inventories fall by the end of the year and the flow remains at 2.5, then it's a great short-term buy. If you're right in your long-term projections, which I think are quite reasonable, then it's a solid long-term buy as well (which is the only time horizon I care about).

WT
---------
Whitney,

I think the 97 thing was APC growing in a step function. It doesn't grow
entirely linearly. Plus there's a seasonal thing in Q1-Q2 as they gear up
inventories in the first quarter in preparation for the summer months, where
you get electrical storms and strains on the power grids from air
conditioning usage.

Dale
Interesting comment about quarter-to-quarter trends. Here's what I came up with for flow ratios:

Q1-Q2: up twice (95, 97), flat in 98 (2.02 to 2.03), down once (96, when they were slimming down after the problems in late 95)

Q2-Q3: up twice, down twice

Q3-Q4: Up three times (including the most recent quarter), down once (maybe this is just seasonal)

Q4-Q1: 3 significant declines; flat once (so if the flow falls in the next earnings release, it might not mean much, but if it rises, that could be a very bad sign).

A couple more things:

1) the inventory issue is not a Q4 phenomenon. Here are the inventory levels since Q4 97: $104M (Q4 97), 131, 200, 223, 229 (Q4 98). A post from the Yahoo board on this topic:

Interrogation of Investor Relations
by: jkrjunior (33/M/Eastpointe, MI), 4/1

I spoke at length with Debbie Grey, APC's IR
person. We talked about their inventory situation. Her
response was inventory has been building since the second
quarter 1998. The inventory didn't just balloon in the
fourth quarter of 1998. This is due in part to new
products in the network and server markets. It can also be
attributed to the Silcon acquisition. In any case, I am more
concerned about their decreasing profit margins.

If
the inventory is primarily finished goods, that
should not be a concern. It isn't like they have
perishable products. Their inventory can stay there for some
time. As long as sales growth is plus 20%, inventory
turns should be okay. The key question though, is will
this cause pricing concerns, and thus gross profit
margin concerns, for their products if inventory
continues to ramp up?

2) An interesting post:

Excellent Value Here
by: Tech_Buyer, 4/2

I can't believe that APC is selling at this price
level and is now testing it's 52 Week low! For no
apparent reason, this stock has been punished to the
extent of companies such as WDC, NSM, and AMD which are
not market leaders, are losing money and have much
slower growth. I do not perceive APC's inventory level
as a big problem since it represents only about two
months worth of sales. Also, the patent law suit is a
joke. It was brought about by an individual, not a
corporation with a large legal team. If APC's management
perceived this as a big problem, they could probably buy
him off cheap. As for the large short interest -
where is it? There were only 711K shares short as of
March 8. Actually, there is not much interest in this
stock at all now, but this will change as APC continues
to post exceptional earnings and growth. The kicker
is that only about 5% of all PC's currently have
power protection. This means there is a lot a room for
growth even if the overall demand for PC's starts to
decline.

3) In contrast, don't you love intelligent posts like this one:

by: friscosr

Time to DUMP this stock and flush it down like a turd in the bowl. This stock sucks.

I thought this one was pretty funny too:

by: Sharps4570a

They already split. They just didn't want to go
through all the hassle of actually doubling the number of
shares outstanding, (all that paperwork!) so they just
cut the price in half. Made the math easier for
management, (smaller numbers!).
---------
Right. I wrote about this yesterday. Inventories bulged in Q2 but never came
down off that level. They consolidated balance sheets with Silcon in Q2.
Part of this is due to undoubtedly expanding dealer inventories, but there's
also key stuff in the MD&A that I don't think the Yahoo poster is
considering. I think this is a step-function growth pattern that is going to
obscure seasonal patterns and that the discretionary buildup of working
capital is not the huge worrying point that the market is making it out to
be. People extrpolate the most recent pattens they see and I just don't
think this is the right way to look at the company. At the very least, I
think net cash from operations can double this year and I've modeled it to
triple subject to some messing around with that model.
Dale

During the fourth quarter of 1998, the Company began establishing
a manufacturing operation in India. The Company will be leasing a 42,000
square foot facility in Bangalore and expects to begin manufacturing selected
products at this facility during the second quarter of 1999.

During the first quarter of 1998, the Company established a
manufacturing operation in China. The Company is leasing a 50,000 square foot facility
in Suzhou and began manufacturing selected products at this facility during
the third quarter of 1998.

The Company's manufacturing facilities in the Philippines are operating
within a designated economic zone which provides certain incentives, primarily in
the form of tax exemptions. In August 1998, the Company purchased a
third manufacturing facility in the Philippines for approximately $750,000,
financed from operating cash. The Philippines facilities manufacture certain
Back-UPS and Smart-UPS products sold in the Company's domestic and international markets.

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