<THE BORING PORTFOLIO>
More on APC
By Dale Wettlaufer (TMF Ralegh)
ALEXANDRIA, VA (April 7, 1999) -- American Power Conversion (Nasdaq: APCC) is still on our radar. We're slothful, we know, but that's how we work. We've been waiting around a little bit because we obviously like to get things cheaper and that's been the trend in anything PC-related recently. That extra price drop past the mid-$30 range was more a margin of safety bonus, however. I believed at the mid-$30 point that APC could generate compounded annual returns of 15% over a multi-year holding period. So at this point we're already looking at better prospective returns.
I did want to look at the financials a little bit more, as the company's inventory position has always been an obvious source of concern for some of the people that follow the company and for some of the people that post on the Fool boards. There are a number of reasons why inventories went up last year, however. APC brought a manufacturing facility online in China in the third quarter and expanded its facilities in the Philippines (APC also began to establish manufacturing operations in Bangalore, India, but that didn't add to finished goods, as it will come online sometime next quarter).
Manufacturing in the Philippines entails longer transit times for finished goods, which means there will be a tradeoff between increased capital costs and better manufacturing costs. As Asian markets grow, the Philippines facility's output will spend less time in transit and more time in someone else's inventory.
APC also completed its acquisition of Silcon A/S, a Denmark-headquartered manufacturer of large power protection systems for multiple servers, mainframes, and business-critical applications.
Nevertheless, it does appear that inventories were not managed as well as they could have been at the end of the year. The real inventory accumulation occurred in the second quarter, at the height of the year (the third quarter is the height of electrical storm activity and power grid failures, which necessitates an inventory buildup in the second quarter). Inventories weren't worked off from that point and another $30 million or so went in through the end of the year.
However, the capital costs on this equity are $3.3 million at an 11% cost of equity. I believe the company benefits from keeping larger inventories to meet sudden demand that frequently arises as the result of some sort of emergency. If you can't meet a network administrator's demands to get product to him or her after a violent thunderstorm, or in advance of an expected heat wave that would tax a power grid, then you're going to lose the initial sale and possibly the annuity value of the follow-on business.
At a 13% level of net margin, the capital cost hurdle represents about 2% of net sales I project for 1999. I'll take the tradeoff between the two and prefer that the company maintain its excellent service reputation. That being the case, though, my first pass at the financial model shows a decline in days sales in inventory to 105 days. Yes, the cash conversion cycle is not that attractive in this business, but the margins are. 3.3 inventory turns a year is not fun. 43-44% gross margin is and 30% return on invested capital is, as well.
My first model on the company shows EPS before goodwill amortization of $1.81 for 1999, which is in the middle of the Zacks' estimates. More importantly, though, the first model shows the company can generate cash flow significantly higher than net income. I still need to work out some of the accruals in the liabilities section, but we're talking about net cash from operations nearing the $200 million level.
Free cash flow, as predicted by the ROIC model and net income, would be around $180 million or so. We're still working with the model and making some refinements. We're open for comments and questions on it on the Boring message board, where I'll also be looking further at First Citizens Bancorp of South Carolina.
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</THE BORING PORTFOLIO>
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Rec'd # Security In At Now Change
6/26/96 225 Cisco Syst 23.96 118.75 395.71%
8/13/96 200 Carlisle C 26.32 43.31 64.53%
2/9/99 100 Gateway 20 72.38 76.69 5.96%
12/31/98 8 Berkshire 2244.00 2330.00 3.83%
Rec'd # Security In At Value Change
6/26/96 225 Cisco Syst 5389.99 26718.75 $21328.76
8/13/96 200 Carlisle C 5264.99 8662.50 $3397.51
12/31/98 8 Berkshire 17952.00 18640.00 $688.00
2/9/99 100 Gateway 20 7237.50 7668.75 $431.25
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