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 Q494 3.3795 2.80 3.74 4.34 4.6196 4.23 3.62 2.42 2.5697 2.56 3.16 2.60 2.3798 2.02 2.03 2.10 2.51Now, 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 towork over a lot of finished goods. That pushed up finished goods rapidly andthen they worked it down. But that's the cycle you see from Q1-end 95through Q1 96. Undoubtedly, value is dependent on cash flow. The latest flowratio numbers are to be expected. I think there is a little inventorybackup, but they're building a global company. You have to like buildingplants in China and India. I've just accepted that this is a high flow ratiobusiness. That's a weapon they use and I think they cover costs oninventory, especially since it doesn't depreciate rapidly. One of thereasons inventory is high is because these suckers are expensive to ship. Abig UPS with a huge battery in it is very heavy. After all, that's a bighunk of lead in there.Here's the model I'm working on. I'm still building out the valuationsection. It's obvious that the market is discounting the working capitalcash flow needs, because if you just discount a bunch of earnings ignoringthose things, it looks like it's worth a lot more. The scenarios in thevaluation models are a little conservative, but better to do it that way. Ifit can manage down its inventories a bit from here, to 105 days, and keep itthere, it's a fine value. On a discounted earnings basis, it's worth in themid-$30s on a conservative basis. The earnings from here should be clean, asI 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 growentirely linearly. Plus there's a seasonal thing in Q1-Q2 as they gear upinventories in the first quarter in preparation for the summer months, whereyou get electrical storms and strains on the power grids from airconditioning usage.DaleInteresting 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 twiceQ3-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 Relationsby: jkrjunior (33/M/Eastpointe, MI), 4/1I spoke at length with Debbie Grey, APC's IRperson. We talked about their inventory situation. Herresponse was inventory has been building since the secondquarter 1998. The inventory didn't just balloon in thefourth quarter of 1998. This is due in part to newproducts in the network and server markets. It can also beattributed to the Silcon acquisition. In any case, I am moreconcerned about their decreasing profit margins. Ifthe inventory is primarily finished goods, thatshould not be a concern. It isn't like they haveperishable products. Their inventory can stay there for sometime. As long as sales growth is plus 20%, inventoryturns should be okay. The key question though, is willthis cause pricing concerns, and thus gross profitmargin concerns, for their products if inventorycontinues to ramp up? 2) An interesting post:Excellent Value Hereby: Tech_Buyer, 4/2I can't believe that APC is selling at this pricelevel and is now testing it's 52 Week low! For noapparent reason, this stock has been punished to theextent of companies such as WDC, NSM, and AMD which arenot market leaders, are losing money and have muchslower growth. I do not perceive APC's inventory levelas a big problem since it represents only about twomonths worth of sales. Also, the patent law suit is ajoke. It was brought about by an individual, not acorporation with a large legal team. If APC's managementperceived this as a big problem, they could probably buyhim off cheap. As for the large short interest -where is it? There were only 711K shares short as ofMarch 8. Actually, there is not much interest in thisstock at all now, but this will change as APC continuesto post exceptional earnings and growth. The kickeris that only about 5% of all PC's currently havepower protection. This means there is a lot a room forgrowth even if the overall demand for PC's starts todecline.3) In contrast, don't you love intelligent posts like this one:by: friscosrTime 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: Sharps4570aThey already split. They just didn't want to gothrough all the hassle of actually doubling the number ofshares outstanding, (all that paperwork!) so they justcut the price in half. Made the math easier formanagement, (smaller numbers!). ---------Right. I wrote about this yesterday. Inventories bulged in Q2 but never camedown off that level. They consolidated balance sheets with Silcon in Q2.Part of this is due to undoubtedly expanding dealer inventories, but there'salso key stuff in the MD&A that I don't think the Yahoo poster isconsidering. I think this is a step-function growth pattern that is going toobscure seasonal patterns and that the discretionary buildup of workingcapital is not the huge worrying point that the market is making it out tobe. People extrpolate the most recent pattens they see and I just don'tthink this is the right way to look at the company. At the very least, Ithink net cash from operations can double this year and I've modeled it totriple subject to some messing around with that model.DaleDuring the fourth quarter of 1998, the Company began establishinga manufacturing operation in India. The Company will be leasing a 42,000square foot facility in Bangalore and expects to begin manufacturing selectedproducts at this facility during the second quarter of 1999.During the first quarter of 1998, the Company established amanufacturing operation in China. The Company is leasing a 50,000 square foot facilityin Suzhou and began manufacturing selected products at this facility duringthe third quarter of 1998.The Company's manufacturing facilities in the Philippines are operatingwithin a designated economic zone which provides certain incentives, primarily inthe form of tax exemptions. In August 1998, the Company purchased athird manufacturing facility in the Philippines for approximately $750,000,financed from operating cash. The Philippines facilities manufacture certainBack-UPS and Smart-UPS products sold in the Company's domestic and international markets.
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