Last Thursday, Bore Port holding (and my own) American Power Conversion (Nasdaq: APCC) reported a solid quarter, with earnings that matched estimates of $0.29 per share. However, management guided estimates downward for the second half of the year, so the stock was obliterated on Friday, falling 44.5%, more than wiping out this year's strong gains.
I believe the next two quarters are an aberration and that APC's long-term story remains powerful and intact, so I view the stock's decline as an opportunity for investors with a long-term horizon and a strong stomach for short-term volatility to add an exceptional company to their portfolio at a reasonable price. However, I haven't added to my holdings yet, as -- call me greedy -- it's not quite cheap enough.
A Little Perspective, Please
While's Friday's drop was dramatic, those with more than a three-nanosecond time horizon -- sometimes I wonder how many of us are left -- should note that APC is now down a mere 2.1% for the year, whereas the Nasdaq is down 10.0% and the S&P 500 is down 2.8%. And since APC was added to the Bore Port on April 20 of last year, the stock is up 78.3% versus 52.0% for the Nasdaq and 8.4% for the S&P 500 (all prices are as of Friday's close).
APC has always been a volatile stock -- it scores only a 15 out of a possible 100 on Value Line's Price Stability index -- so you have to be patient and buy it when it gets oversold. Like now.
Before looking to the future, let's analyze the Q2 results. For the quarter (excluding special charges), relative to the same quarter last year, revenues grew a solid 15.7% and gross margins increased from 43.9% to 44.9%. Though research and development (R&D) rose from 2.8% of sales to 3.2%, total operating expenses dropped from 25.3% to 24.9%, resulting in operating margins increasing from 18.6% to 20.0%. Consequently, net margins soared from 13.6% to 15.9%, triggering a 36% increase in net income. It was the 18th consecutive quarter that APC met or beat consensus estimates.
The balance sheet was equally strong. The company remains debt-free and is sitting on $383 million of cash and short-term investments, equal to 7.4% of its $5.2 billion market capitalization. Cash increased 40.8% year-over-year, though it fell 23.1% from $498 million in Q1.
Days sales outstanding was flat year-over-year at 57 days, down six days from Q1. APC's days of inventory was 108.2 days, a five-day improvement versus a year ago, though an 11.8 day increase from Q1. The Flow Ratio was 2.51, nearly identical to 2.52 a year ago, but a modest increase from 2.36 in Q1.
The net result of the income statement and balance sheet improvements is that return on invested capital for the quarter increased to 34% versus 30% a year ago and 32% last quarter (as reported by the company).
All in all, the slight sequential weakening of the balance sheet and the 15.7% revenue growth made this a solid -- though not spectacular -- quarter.
Management said Q3 earnings would be in a range of $0.29 to $0.35 versus previous expectations of $0.37 (and last year's $0.32), and said the fourth quarter would be "a few cents higher than the third quarter," versus previous expectations of $0.40 (and last year's $0.34). If you take the mid-range of these numbers, APC is forecasting flat year-over-year earnings for the next two quarters. In addition, management declined to make any forecast for the resumption of growth next year. Finally, the wide range for next quarter's earnings is somewhat disconcerting, given that nearly one-third of the quarter is already over. Wall Street hates lack of "visibility." Add it all up and no wonder the stock got whacked!
What's Going On?
APC sells a wide range of products all over the world. APC breaks out its products into enterprise solutions (datacenters, server farms, and the like), networking solutions (e.g., Web, database, and telephony servers), and desktop/home solutions (individual PCs). At the high end, growth is robust and the enterprise segment now accounts for 13.5% of sales vs. 10% at the end of last year. But the desktop segment, which accounted for 29% of sales last quarter, is more competitive and has been characterized by price cutting, so sales grew only 1% year-over-year despite a 15% increase in unit volume. With overall PC sales weak in Q2 and expected to be weak for the rest of the year, APC's results in this area shouldn't be a surprise.
Geographically, APC's sales in Asia continue to boom, up 41% last quarter -- the seventh consecutive quarter of 40%+ growth. Growth was also strong in the Americas, up 21%. In Europe, however, revenues (24% of APC's total) were down 5% due to "continued IT industry softness and unfavorable currency trends." (European sales were up 2% on a constant currency basis.) APC admitted to some execution difficulties in Europe and vowed to fix them.
APC expects these trends to continue for the rest of the year, so revenue growth will be somewhat lower than expected: In Q3, "mid-single digits to mid-teens" organically, plus 5% or so from acquisitions, for total growth of 10-20%. Combined with somewhat lower gross margins ("mid-40s" versus 46.9% in Q3 99) and somewhat higher operating expenses ("mid-20s" versus 23.1% last year), EPS will be approximately flat.
The main story is not revenue growth -- 10-20% topline growth has been APC's range for the past four quarters -- but margins. In the first two quarters last year, operating margins rose to 16.9% and 18.6%, respectively, both about one percentage point better than the previous year. But in the second half, operating margins really took off, to 23.8% and 22.9% in Q3 and Q4, respectively, 3.7% and 2.6% better than the previous year.
This spike in margins was clearly not sustainable if APC hoped to maintain its dominant market share, and the company said so at the time. In the Q4 99 conference call, APC's CFO, Don Muir, said that APC viewed price as "an excellent competitive weapon" and that "long-term gross margins may decline to the mid- to lower-40% range as the product mix shifts to higher-end products, which carry lower gross margins. You won't see margins drop off a cliff, but we're going to be very aggressive on pricing."
Operating margins in the first two quarters of this year were back in line with historical figures at 19.5% and 20.0% -- still healthy increases over 1999. Given APC's guidance on margins, it was likely that without an enormous increases in sales, year-over-year comparisons would be difficult in the second half of this year.
Thus, I think what we are seeing is a two-quarter blip in earnings growth due to exceptionally strong comparisons in 1999. Going forward, APC's earnings growth should closely track its revenue growth, which I expect will continue to be robust.
Key Questions to Ask
To wrap up, let's think about some key questions:
Are APC's fabulous economic characteristics still intact?
Absolutely. APC continues to have exceptional margins and returns on capital, and is minting money.
Is there any sign that APC's competitive position is weakening?
Perhaps there is a bit more competition at the low end, but overall, APC continues to dominate its space.
Is there any sign that APC's markets are smaller or growing more slowly than expected?
There are some questions about the desktop segment, but these are more than made up for by the addition of $4 billion in new markets that APC entered last quarter with the acquisitions of Advance Power (DC power solutions) and ABL Electronics (cable products).
Is power quality around the world getting better?
To the contrary, with deregulation and the enormous surge in demand, power quality appears to be deteriorating.
Has my opinion of where APC will be in five or ten years -- my minimum hoped-for holding period for the stock -- changed?
Not at all.
Prior to last week, APC's estimated five-year EPS growth was 23%. Perhaps that was a little high, but I believe 18-20% is reasonable. With APC now trading at approximately 18x next year's revised earnings of $1.45/share -- a depressed multiple in my opinion, given APC's economic characteristics and prospects -- I expect APC to compound at an average rate of 20-25% annually for quite a few years. I'll take that any day.
-- 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.
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