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Ingram Micro's Maxi Prospects

By Megan Graham-Hackett The information technology (IT) distribution industry is facing challenges, in Standard & Poor's Equity Research Services' view, and market-share battles have become fierce. We believe Ingram Micro (IM

; recent price, $19) is well positioned to gain share -- and offset competitive pressures -- due to its ability to leverage its reach as the only global broadline IT distributor. We also like what we consider Ingram's competitive advantage in offering unique services, reflecting investment in its own IT infrastructure, including advanced e-commerce tools.

We see the potential for margin expansion, as Ingram benefits from streamlined operations in North America. We believe the company's November, 2004, acquisition of Tech Pacific will prove to be a critical asset, enabling Ingram to better tap rapid growth in the Asia Pacific region as well as benefit from higher-margin sales. Tech Pacific is the only global full-line distributor with operations in the Asia Pacific region, which we view as a hotbed of future growth.

We believe the stock's price-to-earnings multiple should expand, as the company's operational consistency, margin improvement, and market-share gains begin to be reflected in the shares' valuation. Ingram carries S&P's highest investment recommendation of 5 STARS (strong buy).

SMART BUYS. IT distributors are essentially the link between suppliers and resellers. But this role has evolved over the years. The increased commoditization of hardware and software products has caused suppliers and resellers to shift their focus toward more services and broader offerings. In addition, we believe the shift in focus among resellers has caused them to require distributors to offer value-added services customized to the needs of their specific customer base.

Ingram's position as the largest global IT distributor has evolved through a series of acquisitions. Among significant deals in recent years, the company enhanced its presence in Europe in 1998 with the acquisition of Macrotron, and in November, 2004, strengthened its position in Asia Pacific with the acquisition of Singapore-based Techpac Holding (Tech Pacific). This acquisition broadened its capabilities in the retail channel, third-party logistics, software distribution, and traditional distribution segments in the region. The buy boosted Ingram's total distribution centers from 48 in December, 2003, to 70 as of January, 2005, and essentially doubled its Asia Pacific presence.

In addition to geographic expansion, Ingram has tapped adjacent market opportunities via acquisitions, with the purchase of Nimax, a value-added distributor of automatic identification and data capture/point of sale (referred to as AIDC/POS). It has also moved into consumer electronics, with the July, 2005, acquisition of certain assets of AVAD, a leading distributor of home technology integration products.

THINKING SMALL. The IT-distribution industry has notoriously low margins. However, to offset this pressure, Ingram has focused on efficiency to drive competitive advantage and differentiation. In our opinion, Ingram's focus on reducing costs by leveraging its IT systems and warehouse locations for optimal delivery efficiency and lower costs has supported margin expansion and also enhanced market-share opportunities.

Ingram has focused on targeted programs to tap the critical small- to medium-sized business (SMB) segment, and the company has broadened its reach to developing markets globally in order to capture higher growth opportunities. We believe the SMB segment is an area where IM can better aggregate customers and provide value-added services. In addition, this segment has demonstrated increased IT spending at a faster rate than the overall global growth rate.

Ingram has been innovative in terms of its focused value-added services, in our opinion. Its services include supply-chain offerings which leverage its global experience to help clients deliver products to new markets on a fee-for-service basis. That means customers can benefit from the ensuing volume efficiencies.

MAJOR PARTNERS. Ingram's suppliers (or vendors) span the computer-hardware, networking-gear and software markets, and include: 3Com, Acer, AMD, Canon USA, Cisco Systems, Computer Associates, Epson, Hewlett-Packard (HP), IBM, InFocus, Intel, Iomega, Juniper Networks, Kingston Technology, Lexmark, Maxtor, Microsoft, NEC/Mitsubishi, palmOne, Philips, Samsung, Seagate, Symantec, Toshiba, Veritas Software, ViewSonic, Western Digital, and Xerox.

Products from HP generated some 22% of Ingram's net sales in 2004. With new management at the tech giant (Mark Hurd became CEO in March, 2005), the question has been whether Ingram's relationship with HP would change. However, we believe recent signals can be viewed favorably. HP has established which accounts will go direct (we think this reduces confusion and uncertainty), and has also eliminated its outbound calling center for direct accounts (it's now inbound only).

Ingram deals with most of the leading resellers of IT products and services. In the U.S., these include,, CDW, CompuCom Systems, CompUSA, Insight Enterprises, Office Depot, OfficeMax, PC Connection, and SARCOM. Outside the U.S., customers include Bechtle, Brasoftware, Compugen, Econocom, Future Shop, Mainbit, NexInnovations, and Systemax.

STRATEGIC SELECTION. The largest category in the company's business mix is peripherals (which account for 40% to 45% of sales), such as printers, displays, mass storage, and tape, as well as the company's new consumer-electronics business. Systems, the next largest category (20% to 25%) includes desktops, laptops, and servers. Software accounts for 15% to 20% of sales, and networking equipment 10% to 15%.

Systems sales have increased above the company sales growth average for several quarters now, reflecting, in our opinion, the shift to laptops (as price points were low enough for users seeking mobility to chose them over desktops) and a PC product refreshment cycle. We believe networking contributions have been under pressure, as Ingram has become more selective in which vendors it works with, a strategy we view positively.

The company has generated operating-margin improvements since 2002, aided by initiatives during the 2001 through 2003 period. We expect this trend to continue. Indeed, Ingram beat its target (150 basis points) for operating margins in North America in the 2005 third quarter by 7 basis points, and we believe this level is sustainable.

THICKENING MARGINS. Ingram established process-optimization programs over the past 18 months and is now beginning to enjoy the benefits, in our view. While it hasn't established operating-margin targets for the other regions, we think there has been significant progress in Europe (despite stiff pricing pressure) and Asia Pacific (despite continued investments in the region).

The margin expansion we anticipate supports the 14% earnings per share growth we see for 2006, before stock-option expenses. We project revenue growth of 5%, as the drag from currency translations weighs a bit on the company's growth in Europe, and coming off high growth rates in Asia Pacific in 2005, reflecting contributions from the Tech Pacific acquisition.

We believe positive signals for Ingram's 2006 revenue growth include recent signs that pricing in the industry has become more stable, that the company can leverage share gains internationally, as well as new categories it has added through acquisitions (e.g., consumer electronics).

OPTION EXPENSES. Our Standard & Poor's Core Earnings estimate for 2005 is $1.21 a share, which is 10% below our operating estimate, reflecting the impact of stock-option expenses. For 2006, we expect that impact to narrow, with stock-option expense reducing EPS by about 7%. However, we note that beginning in 2006, companies will be required to include these expenses in their income statements. So our operating estimate for 2006 of $1.42 includes stock-option expenses.

There has been no uniformity among the companies we cover on whether they will prepare a "pro forma" EPS figure that excludes stock-option expenses in their earnings releases in 2006 to assist in year-over-year comparisons. Most indicate that they're still evaluating possibilities and are seeking guidance from the SEC, as well as waiting to see what peers do.

We believe companies such as Ingram, which have a relatively small exposure to stock-option expenses (we estimate the impact on Ingram's EPS at less than 10% in 2006, compared with many tech companies that we think will witness a dilution of some 20% to 25%), will likely include these expenses in their income statements. We also expect them to include the impact from key items such as cost of goods sold, SG&A, and R&D in footnotes to financial statements.

PEER COMPARISON. Our valuation analysis utilizes our historical price/earnings (p-e) model as well as our

discounted cash-flow analysis. However, in Ingram's case, we have found that using p-e analysis to establish the shares' value has proven to be more reliable.

Over the past five years, Ingram has traded at an average p-e of 25.3 times (using current year earnings in each year), with the peak being 33.8 times and the trough 16.9 times. Based on these historical levels as well as peer levels, we believe a reasonable p-e of 15 times (excluding stock-option expenses) and 16 times (including stock-option expenses) can be applied to our 2006 EPS estimates, which yields our 12-month target price of $23.

In addition, Ingram trades at a similar price-to-sales multiple as 3 STARS (hold)-ranked Tech Data (TECD

; $40) despite having wider operating margins and a higher return on equity (ROE). This differential should support Ingram's multiple expansion, and thus share-price appreciation, going forward.

STRONG GOVERNANCE. We view Ingram's track record in asset management positively. The company has focused on managing accounts receivable, and has significantly reduced its investment in inventory to yield a track record of strong working capital management and solid financial position, in our opinion. Ingram's free cash flow growth improved significantly in 2004 from 2003, which is reflected in our DCF model.

We believe that the company will need to balance investments in new markets (i.e., China, as well as acquisitions) going forward, but we see further opportunities to improve working capital management. We also highlight the fact that the company continues to review stock buybacks as a way to enhance shareholder value, but doesn't currently have a buyback program in place.

We believe the company compares favorably to its peers and the broader market as far as corporate-governance practices. We view positively the fact that Ingram has a corporate governance committee and has published guidelines dictating its policy with regard to board directors' independence, management compensation, and management succession. On the negative side, the board's chairman is a former CEO of Ingram (this isn't uncommon among companies in our coverage universe).

PRICING PRESSURE. We have identified several risks to our recommendation and target price. Ingram typically gives guidance one quarter out, so visibility is arguably somewhat low. Given the slim margins in the IT-distribution business, we believe any sudden slowdown in the broader economy or in technology spending could cause earnings to fall materially short of expectations.

In addition, significant pricing pressure has been an issue in late 2004 and early 2005, and while it has abated somewhat during the second half of 2005, price competition could intensify again in the near term. Ingram relies on Hewlett-Packard (HPQ

; 3 STARS; $29) products for more than 20% of its sales, and loss of this supplier or any other major supplier or customer is a significant risk.

Finally, management has executed reasonably well in our estimation, but this doesn't preclude future missteps from occurring, especially with at least part of the company's growth strategy focused on using acquisitions to enter new markets (i.e., adjacent technology markets).

Analyst Graham-Hackett follows shares of computer hardware stocks for Standard & Poor's Equity Research Services

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