An Investment Opinion
Look at CompUSA (NYSE: CPU), the once successful chain whose stock fell from more than $30 in 1997 to around $6 before Grupo Sanborns, a Mexican-based retailer, bought it out this month. Price wars and direct sales manufacturers like Dell (Nasdaq: DELL) decimated the company's profit margins. It's a business model that looks old and weak.
But there are a couple of tough, fast-growing catalog retailers that are making money, fine-tuning their business models, and Web-enabling their businesses just as pure-play Internet retailers like Buy.com (Nasdaq: BUYX) and Cyberian Outpost (Nasdaq: COOL) are struggling.
CDW Computer Centers (Nasdaq: CDWC), founded in 1982 by Chairman and CEO Michael Krasny, has carved a profitable niche by assembling an aggressive company with a business model light as a silicon chip. The Vernon Hills, Illinois reseller has no debt, is expected to grow earnings 26% annually, and is starting to generate good cash flow in an industry where it's hard to rub two nickels together.
Insight Enterprises (Nasdaq: NSIT), sells over 100,000 products business, government, and education customers in the U.S., Canada, and Germany. Founded by brothers Tim and Eric Crown in 1984, Eric got a 'C' when he drew up the Insight business plan for a college course. The Tempe, Arizona company has racked up 18 consecutive quarters of sales and earnings growth, and, better yet, is starting to spin off free cash and generate strong returns on equity.
A little background. There are a lot of ways to sell computers. Dell wrote the book on the direct-sales model, which skips the sales channel and goes right to consumers and corporations. On the other end is Compaq (NYSE: CPQ) -- which is moving towards a more direct model -- but sells mainly into the sales channel to distributors, which in turn sell to retailers. It's a tough way to make a buck since every player in the food chain takes a cut of profits.
CDW and Insight are part of that food chain. They're direct marketers of computer products, which means they buy products from manufacturers to sell to end users via catalogs, telesales, and a fast growing Web presence.
From a Fool's point of view there are a lot of strikes against CDW and Insight, which have gross margins of 13%, and 12% respectively, and net margins of 4%, and 2%. Neither company has any intellectual property it can use to build a barrier around its business, and they don't have pricing power since they don't manufacture anything (though they're gaining leverage as they build scale).
In addition, major manufacturers, looking to emulate Dell, are selling more products directly. As a result they've cut back on price protections offered to channel partners like CDW and Insight, a trend that's accelerating and could eat into the duo's potato chip margins. All told, it doesn't look like the companies have control over their destiny.
But before you toss them onto the scrap heap of misfit stocks, consider this. They are operationally superb companies. CDW generated $2.5 billion in sales on just $424 million in average total assets last year, giving it a total assets turnover ratio of six. Insight cranked out $1.5 billion in sales on an asset base of just $375 million. These are two lightweight companies with punching power.
The assets turnover ratio (sales/average total assets) seeks to measure how effectively a company manages its assets. The higher the ratio the smaller the investment needed to generate sales and the more profitable the firm. Six is remarkable, and CDW isn't selling products below cost or living on ad revenue. It's been around more than 15 years and makes a real, economic profit.
For comparison, go back to 1994 when Dell had $2.9 billion in sales, on average total assets of $1.03 billion. Even if you back out the cash, Dell had an asset turnover ratio around 3.6, a bit higher than it has today, and quite a bit less than CDW's. In other words, it needed a heavier asset base to generate roughly the same sales.
Looked at from another angle, CDW is generating an amazing $6 in revenues from every dollar of assets. This means CDW has less money tied up in expensive fixed assets and more available to hire highly productive sales people, who generate roughly $3.2 million in average annual sales, and represent about 40% of the company's workforce. The company is a sales machine.
Let's look at two other ratios that measure operational efficiency: Inventory turnover, and the cash conversion cycle. Inventory turnover is critical in any industry, but especially so in the computer business where a steady stream of new products lead to rapid depreciation.
CDW turned its inventory 24 times last year, already an impressive number, but even more so since it has increased from 21 times two years ago. Now look at Insight, which turned its inventory a whopping 52x last year. It's not just a sign of good inventory control, but of a strong sales force that knows how to move product.
On the cash conversion front, which measures how fast a company turns raw materials into cash, CDW looks pretty efficient at 9x per year, while Insight pretty much rules the roost at an amazing 26x per year. That represents millions in cash freed up to pursue new opportunities, keep creditors at bay, repurchase stock, whatever.
Now, neither company is generating a lot of cash relative to sales or net income at this point, but I'd look for that to ramp up since both companies generate such high returns on total capital. That's what's amazing about these companies: They're very profitable despite such low margins.
CDW's returns on total capital stand at 30%, way above its cost of capital, which is probably around 12%. (The company has no debt, so its cost of capital is probably a little higher than it has to be.) There are few companies that enjoy this kind of spread between profits and cost of capital, especially in the retail industry.
A cloud on the horizon is Dell, which represents the biggest threat to both companies' growth. See, CDW and Insight have made a niche for themselves selling to small and medium sized businesses. The bulk of Dell's customers are Fortune 500 companies, but that's changing as Dell spreads its wings. The market for low-end servers, PCs, notebooks, and portables among small and medium-size businesses in the U.S. stood at $28.3 billion in 1999, according to market research firm IDC. About 14.6 million units were shipped last year and that number should grow to 24.4 million in 2004.
You bet Dell wants a piece of that action, and it's mobilized to get it. Can CDW and Insight compete? It should be fun to watch as Dell really gets up to speed, though it could take time since Dell's inexperienced in the fragmented small-medium business (SMB) market. I'd look for CDW and Insight to hang tough and continue growing quickly.
For the record, I think computer resellers are like lawyers. There are way too many, but there's always room for a good one. CDW and Insight are still the players to beat in this space.