S&P's Cathers says margin pressures and a lackluster PC upgrade cycle may leave many distributors without enough growth to spark shares
Lately, there has been a clear divide in the performance of technology distributor stocks. Distributors of the nuts and bolts used to make electronic gadgets like cell phones—namely, Arrow Electronics (ARW) and Avnet (AVT)—have surged 25% and 43%, respectively, this year (through Feb. 26) thanks to strong demand for storage and other components. Meanwhile, the shares of distributors of finished goods like PCs, servers, and printers—such as Ingram Micro (IM) and CDW (CDWC)—have been left in the dust.
The trouble is, tech distributors of all stripes face intense competition and slim margins, says Dylan Cathers, who follows Ingram Micro, CDW, SYNNEX (SNX), and Tech Data (TECD), which have all lagged behind the market this year. His favorite stock is Ingram Micro, given its attractive valuation, strong balance sheet, and expansion into high-end home electronics systems, along with its other efforts to boost margins.
BusinessWeek.com's Karyn McCormack spoke with Cathers on Feb. 26 about the tech distributors for mostly finished goods. Edited excerpts from their conversation follow.
Note: Dylan Cathers is an S&P Equity Research analyst. He has no ownership interest in or affiliation with any of the companies on which he writes research. All of the views expressed here accurately reflect the analyst's personal views regarding any and all of the subject securities or issuers. No part of the analyst's compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed.
What's your overall outlook for technology distributors?
We have a neutral fundamental outlook on the industry. We think that the tech distributors are seeing pockets of demand. According to research firm IDC, packaged software is supposed to continue to be strong—with upper single-digit growth from 2006 to 2009. Sales of complete systems are expected to be a little slower, with declines in traditional workstations. Sales of desktops are also slowing down. IDC sees low single-digit growth for desktop systems, while laptops should see much stronger growth. Laptops have higher average selling prices (ASP), and though we don't have hard and fast data, we believe margins are better for laptops. Network equipment should see good growth over the next couple of years—that's the steady grower in tech.
In terms of geography, Asia/Pacific is growing the fastest, given the growth of businesses in China, India, and the rest of Southeast Asia. Essentially, companies setting up shop there need equipment. The U.S is the middle grower. And for the companies we follow, Europe has been one of the slower growth areas. There's a caveat there because HP (HPQ) went through a vendor rationalization in 2006. They were dealing with too many distributors in Europe, and some suppliers had 10% of their business with HP. When HP cut back on its distributors, some smaller companies lost business. So they had to dump their product, and that led to margin pressure in Europe.
There was some consolidation in the group a few years ago—do you see any more deals?
We don't see any major moves coming. We think you're more likely to see the large companies that we cover buying smaller companies. The large companies are looking to diversify geographically and offer new products.
What else are these companies doing to grow?
What we're finding interesting is some of them are going outside of the box. For instance, Ingram Micro is selling, through one of its businesses, high-end stereo equipment to installers (not directly to consumers). A lot of the large houses that have been built lately have included movie studios and large rooms needing stereo equipment.
Another company, CDW, which mainly sells finished goods to corporations and schools, bought Burbee late last year to get into some services such as productivity applications. It's more on a localized basis that goes hand in hand with what they're selling.
What are the challenges faced by technology distributors?
All of them are having issues with margins. Operating margin for SYNNEX was 1.5% last year. Ingram Micro's was 1.3% last year, and Tech Data was under 1%. So these are slim margins, and any way they can offer higher-margin products, like services and electronics, will benefit them.
They're doing everything they can on the cost side. They're opening warehouses in strategic locations and installing cutting-edge inventory systems. But at the end of the day, they're just distributors—all they can do is charge the next person in the chain more money. The challenge is competition. How do they increase margins? And especially in tech when you have too many widgets, it's just a matter of time before you see price pressures. They need to run mean and efficiently. Because of competition, they try to do that in their own way.
The stocks of these companies ran up in the second half of last year, and many of them have pulled back this year because they're under margin pressure amid the competition and investments. But those investments are vital because if they don't make them, someone else will.
Which ones do you think show the most promise, and why?
We've got a strong buy on Ingram Micro—it has been 5 STARS for a while. Ingram Micro offers the most compelling valuation at the moment. It's selling at a price-to-earnings growth (PEG) ratio of about one, which is a good bit below its peers. We arrive at our $24 target price using a PEG ratio of 1.2, based on our 2007 earnings-per-share estimate of $1.68 and an expected three-year growth rate of 12%.
They also have a strong balance sheet. When you have a balance sheet like that, with $335 million (or $2 per share) in cash and a debt-to-total-capital of under 9%, the company has the flexibility to make investments that perhaps its competitors can't make.
Another reason why we like it is the company is taking steps to improve margins. For instance, it purchased a consumer-electronics business. It also opened a services business last year and it has upgraded to a more efficient warehouse-management system in its distribution center near Munich. The company sells everything—including computers, printers, software, and network equipment—throughout the world, and does a very good job of managing its portion of the supply chain.
What are your recommendations on the other companies?
We have a hold on CDW, SYNNEX, and Tech Data. (In January, we upgraded Tech Data and CDW to hold from sell after the stocks dropped following their earnings releases.) These three stocks have PEG rates that are a little high for our taste, but the growth rates are not bad. The valuations are not compelling enough to raise our recommendation at the moment. My colleague Jay Hingorani has a buy recommendation on Arrow Electronics and a hold on Avnet.
Do you see a catalyst for these stocks?
There doesn't appear to be any real impetus or catalyst over the near term to drive revenue and earnings growth. They all saw some margin pressure in the fourth quarter. We don't see a big PC refresh cycle, and don't see a lot of excitement around Microsoft's (MSFT) Vista. So there is no huge need to buy more material, especially considering our forecast for slower economic growth in 2007.