ADDvantage Technologies (AEY) is a well known stock among value investors in micro cap stocks. Whopperinvestments.com has covered the stock extensively and has a position. In a post today he poses the question Is it time to bail on ADDvantage Tech? For now Whopper continues to hold.
Another perspective was offered a few days ago by Booth Laird in this post: Management has the ADDvantage.
I have also owned the stock, but I have sold my shares recently (but before these posts). I struggled to make this decision. In this post I want to discuss what eventually made me decide to sell.
Capital allocation is an important factor for me. I thought AEY did a reasonable job until recently. They have made a good, fairly small acquisition in May 2011 (Adams Global) that fits in with their current business. After that they decided to drastically reduce their debt. I think these decisions made a lot of sense. Their business has slowed down significantly, because an agreement with Cisco was terminated and because cable industry spending as a whole was down. Making a small acquisition and reducing debt were good conservative decisions in these circumstances in my view.
I followed a number of conference calls to hear what management’s plan was on future capital allocation. As you would expect, in most calls questions were asked about buybacks and dividends.
Management always responded fairly negative towards this and pointed to the debt the company had and the low volumes of the stock that would be an obstacle for a buyback. At one point (I don’t remember which conference call this was) I heard management respond to a question about dividends and they appeared to have changed their tone somewhat and seemed to be more open about the idea of a dividend.
But management did not follow up on this idea in the quarters since that conference call. On the contrary: in the last conference call they said that at the current stock price they are not really interested in buying back shares and prefer to look for an acquisition.
An investor in AEY needs to answer the question if the $22.7m in inventory on the books is realistic. I was disappointed to see a significant inventory write off this year. That was another factor that made me decide to sell.
The role of the new CEO
One thing I disagree with in the post on the Booth Laird site is the role of the CEO in all this. I believe the ownership situation in a stock, especially in micro caps, usually determines the strategy of a company. Here we have two brothers – Ken and David Chymiak – owning roughly half of the shares.
I just do not believe that they would let a CEO talk them into making an acquisition. I think the brothers perhaps even initiated the idea. So, I don’t see this situation as an agency problem. Major owners tend to make sure the CEO does what they feel is right. I don’t think the CEO would be there in the first place if the Chymiak brothers were not enthusiastic about the idea of an acquisition.
The question an AEY investor needs to answer is: why would a 50% owner of a stock prefer an acquisition over a buyback or dividend at the current stock price?
One possibility, besides the agency issue, might be that the decline in their business is worse than anticipated and that one or more acquisitions are necessary to stay profitable in the long run. Management has made a successful acquisition in Adams Global, but how would results have looked like this year without Adams?
Initially I bought AEY because I believed the share price would recover if results improved a little and / or the company would buy back shares or start paying a dividend. You could summarize it as mean regression and better capital allocation. Both have not happened. Worse: buybacks are very unlikely at this point, considering the comments from management and their controlling position. An activist will probably not be able to accomplish anything here.
I figured my reasons for investing are no longer present. Instead I would now be betting on management to make a successful acquisition. They might well do that, but I’m not willing to bet on it. I prefer situations where market sentiment about a depressed stock improves or good capital allocation causes the stock to rise. I fear AEY is more and more becoming a turnaround investment and I simply do not have the industry knowledge to be able to judge if management can make it happen.
It was difficult to sell this stock at such a depressed price and large discount to book value, but I have to make decisions looking forward and not backwards. Looking forward I see other stocks that have better capital allocation than AEY and similar discounts to book value. I prefer to own those. I hope to post later this week or early next week about a Japanese stock I’m currently looking at.
Disclosure: no position.