Boring Portfolio American Power Conversion's Ugly Earnings

When APC reported Q3 earnings last Thursday, it missed estimates and guided estimates down significantly for Q4 and next year. Not surprisingly, the stock blew up (for the second time in three months), falling 40% on Friday, and it's now down 74% from its July high. Revenue growth is slowing, profit margins are being squeezed, and free cash flow is slowing to a trickle. Time to sell? Not so fast.

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By: Whitney Tilson
October 30, 2000

In my column three weeks ago, I warned that many of the most popular technology stocks remained dangerously overvalued, and instead suggested that investors seeking opportunities in this sector consider such beaten-down stocks as American Power Conversion (Nasdaq: APCC) and Apple (Nasdaq: AAPL). Ooops! While three weeks is hardly a meaningful period of time, I have to confess that I'm busy wiping the egg off my face and trying to get rid of the goat horns that mysteriously appeared on my head.

The first part of my argument has been right on so far, as five of the six stocks I cited as being too richly valued have declined (by an average of 10.1%), but Apple and APC laid big fat goose eggs in their recent earnings reports and have fallen 16.3% and 27.1%, respectively, since then (all prices as of Friday's close). So that no one accuses me in the future of writing about certain stocks I'm buying and then selling them without notice, I am now giving notice that I am now seriously reevaluating whether I want to continue holding these two stocks and may sell all or part of my positions in the near future.

Incidentally, if you bought either Apple or APC based on my writings, I feel badly about that -- and rest assured, I feel your pain. But if you blame me, then consider that in my opinion there are two types of investors: those who do their own analyses, make independent decisions, and take responsibility for them, and those who blindly follow others' investment ideas, taking credit for successes, and casting blame for disappointments. Guess which type of investor is more likely to succeed over time?

Today I'd like to review American Power Conversion, and then analyze Apple next week.

American Power Conversion
Because of the uncertainty surrounding the earnings warning APC issued three months ago, I knew that I was sticking my neck out when I recommended the stock. The danger of such situations is that there is often a "cockroach problem": just as when you find a cockroach, there are usually many more, when a company announces disappointing news, there is often more to come.

I didn't think this was the case with APC and, as I argued in my July column, I felt that the weak earnings the company projected in Q3 and Q4 of this year were due primarily to APC's exceptionally strong second half of 1999, making this year's comparisons difficult. Unfortunately, I was wrong. When APC reported Q3 earnings last Thursday, it missed estimates and guided estimates down significantly for Q4 and next year. Not surprisingly, the stock blew up (for the second time in three months), falling 40% on Friday, and it's now down 74% from its July high. You'd think this was some profitless dot-com, wouldn't you?

The Numbers
In Q3, APC's revenues grew 11% year-over-year and 8% sequentially, but excluding two acquisitions, growth was only 6% and 7%, respectively. Gross and pro forma net margins dropped significantly to 42.5% and 15.0%, versus 46.9% and 17.5% year-over-year and 44.9% and 15.8% sequentially. As a consequence of slow top-line growth and declining margins, APC reported pro forma EPS of $0.30, at the low end of the $0.29 - $0.35 range the company gave last quarter, two cents lower than Q3 99, and three cents below consensus expectations.

While these numbers are disappointing, I'm more concerned about the future challenges the company faces, which are reflected in the reduced guidance for next year, and APC's weakening (though still strong) balance sheet. The company guided next year's EPS estimates down to roughly $1.20 - $1.31 (versus expectations of $1.43), which would represent only 5-15% growth over this year's figures, on revenue growth "in the low- to mid-teens." This means that APC projects a continued decline in margins next year, a worrisome sign.

In addition, the balance sheet worsened on nearly every dimension -- not dramatically, but troubling nevertheless. Inventories and accounts receivables rose 29.3% and 15.1% year-over-year and 14.6% and 10.8% sequentially -- in all cases, faster than sales -- causing the Foolish Flow Ratio to rise for the third consecutive quarter. Since Q3 99's 2.56, APC's Flow Ratio has been 2.29, 2.36, 2.51, and now 2.73, its highest level in more than three years. Finally, cash and short-term investments declined for the second quarter in a row, to $364.8 million versus $382.7 million last quarter -- though it's up from $330.9 million in Q3 99.

I didn't like to see the declining cash, not because it's at an unhealthy level -- it's equal to 14.7% of APC's market cap today and there's no debt -- but because of what it says about free cash flow. After I wrote my July column on APC, the company issued its 10-Q for Q2, which showed that operating cash flow was only half that of Q2 99, and in addition capital expenditures had tripled. Despite a robust 32% gain in year-over-year earnings per share, APC's cash flow from operations was -$17.7 million versus +$61.1 million in the second quarter of 1999. To be fair, one should add back a $47.2 million charge for the resolution of a patent dispute, yielding adjusted operating cash flow of $29.5 million, a 52% drop versus the same quarter the previous year. The decline was not due to any single item on the cash flow statement: accounts receivable, inventories, accounts payable, and income taxes payable all contributed.

In addition, capital expenditures jumped to $28.4 million from $9.6 million in Q2 99. The result was free cash flow of $1.1 million in Q2 00 versus $51.5 million in the same quarter the previous year. Thus, with essentially zero free cash flow to offset spending $127 million on two acquisitions and the payment for the patent litigation, APC's cash in Q2 00 declined sequentially by $115.6 million. Now, given the further cash decline last quarter and the weakening of other items on the balance sheet, I suspect that free cash flow was again nearly flat. Significantly deteriorating cash flow is a big warning flag for me when I'm considering investing in beaten-down stocks, and I'm kicking myself for not acting on it when I saw APC's 10-Q for Q2.

What's Going On?
During its conference call, APC said that it is not losing meaningful market share in any area, and instead gave a number of explanations for its difficulties:

  • Sales of desktop PCs, especially in the corporate space, are weak, which reduces demand for APC's ancillary products;
  • European sales growth was only 8% due to the decline of the euro. It was up 16% on a constant-currency basis;
  • APC reported lower sales of its new systems and instead said there has been a year-over-year doubling of revenues from replacement batteries for its products -- more evidence that businesses are slowing down their capital expenditures for technology equipment. (Yet another reason why I'd be sweating bullets right now if I owned any tech stocks whose extraordinary valuations were contingent upon continued heavy buying by corporate America.)
  • Companies are increasingly consolidating their servers or subcontracting with "server farms," both of which mean that more servers are plugged into one APC product, thereby reducing demand;
  • Margins are being compressed because the most rapid growth is coming in the high-end enterprise space where, as the company said during the conference call, "there are entrenched competitors" and "we're not the leader." (In the high-end area, APC's gross margins are 30% versus 45% for the slower-growing core businesses.)

Of these five factors, the last one is of greatest concern to me. APC acknowledged that its future growth is largely dependent on how successful it is in these new areas -- something even the company can't predict.

Buy, Hold, or Sell?
Given all these issues, it's time to quickly sell the stock, right? Not so fast. It all depends on today's valuation and your future expectations. With the stock now at $12.75, APC trades for 9-11x next year's earnings, depending on which estimates you want to use. (One would hope that APC's management has learned its lesson and has set expectations far below what it expects to achieve.) Despite recent problems, the company has many strengths, as I've highlighted in previous columns (links above): It still has enormous margins, generates very high returns on capital, has a strong balance sheet, and remains the dominant market leader in its core business. The company also continues to invest heavily into rapidly growing new markets.

The key questions are whether APC's difficulties will be temporary and, if so, how long will it take for the company to rebound and how strong the rebound will be. I think the answer to the first question is yes. After all, it's not as if APC is alone in its difficulties -- many companies have been hurt by slowing PC sales and reduced capital expenditures on tech hardware, but there's little doubt that there will be robust growth in these areas for many years to come.

Conclusion
The bottom line for me is that APC's highly profitable core business -- even if one assumes that it becomes a slow-growth cash cow -- is probably worth the company's depressed valuation. Thus, the new markets APC is targeting represent free options.

If you believe that the company's financials will stabilize and that it will be able to grow at, say, 12-15% over time, then the stock will likely return to a multiple double or triple that of today. In this scenario, today's buyers who have at least a two-year horizon are likely to be well rewarded. However, I don't think the rebound will come quickly, so the stock, while already cheap, could get quite a bit cheaper.

-- Whitney Tilson

Whitney Tilson is Managing Partner of Tilson Capital Partners, LLC, a New York City-based money management firm. Mr. Tilson appreciates your feedback at Tilson@Tilsonfunds.com. To read his previous guest columns in the Boring Port and other writings, click here.

Boring Portfolio


10/30/00 as of ~8:30:00 PM EST

Ticker Company Price
Change
Daily Price
% Change
Price
APCCAMER POWER CONVERSION0.251.96%13.00
BRK.BBERKSHIRE HATHAWAY'B'94.004.72%2085.00
COSTCOSTCO WHOLESALE CORP0.882.60%34.56
CSLCARLISLE COS1.814.65%40.81
GTWGATEWAY INC0.310.62%50.60

  Day Week Month Year
To Date
Since
10/1/1998
Annualized
Boring2.84%2.84%(3.46%)(11.62%)25.15%11.37%
S&P 5001.38%1.38%(2.63%)(4.80%)37.52%16.52%
S&P 500 (DA)1.37%1.37%(2.60%)(4.75%)39.23%17.22%
NASDAQ(2.65%)(2.65%)(13.11%)(21.57%)88.41%35.53%

Trade Date # Shares Ticker Cost/Share Price Total % Ret
8/13/96200CSL26.3240.8155.03%
2/9/99200GTW36.2850.6039.48%
9/13/99220COST34.5534.560.03%
12/31/9812BRK.B2,278.332085.00(8.49%)
4/20/99460APCC14.4813.00(10.20%)

Trade Date # Shares Ticker Total Cost Current Value Total Gain
8/13/96200CSL5,264.998,162.502,897.51
2/9/99200GTW7,255.5010,120.002,864.50
9/13/99220COST7,601.147,603.752.61
4/20/99460APCC6,659.255,980.00(679.25)
12/31/9812BRK.B27,340.0025,020.00(2,320.00)
 
Cash: 
Total: 
10,490.51
67,376.76
 

Key
• S&P 500 (DA) = dividend adjusted. Dividends have been added to the total return of the index.