Advant-E is a small e-commerce software company that is showing strong growth while remaining undervalued by the general market.

As a tiny player in the huge Information Technology field, ADVC has managed to carve out a solid niche and continues to throw off cash at impressive margins.

While many software companies trade at outsized multiples which reflect the general attractiveness of the industry (margins are certainly impressive in the software business), ADVC trades with a P/E ratio of under 10.

Despite increases in revenue, EBIT, and net income during this past year, the stock price actually declined in 2010, closing the year trading at multiples below its long-term averages.

Industry and Technology Overview

Sales are broken out into two reporting segments:

Edict Systems

Edict Systems offers Software-as-a-Service (SaaS) solutions primarily to small and medium businesses to assist in Electronic Data Interchange (EDI), a fancy term for the act of sending and receiving business documents (such as purchase orders) electronically using a standardized format.

In the retail space in general, large purchasers have significant power over the wide array of small and medium suppliers that hope to gain their business.

Once a large purchaser starts conducting business via EDI – an attractive ROI proposition for a big company – they force their suppliers to comply or face significant financial penalties.

Edict Systems provides an easy-to-use web-based EDI solution at a low price point, ranging from $50 – $250 per month, for suppliers to convert and send their documents electronically.

Unusually, Edict charges the suppliers, and allows the large purchaser to get the benefits for free.

This means other suppliers must pay to stay competitive, or potentially lose a large customer.

As more documents are sent using EDI – signifying that the supplier is theoretically making sales – ADVC shares in that success via their volume pricing, a nice business model.

Merkur Group

The Merkur Group is more of a traditional IT business, offering software and services that are delivered on-site and hooked into existing Supply Chain Management (SCM), Customer Relationship Management (CRM), and Enterprise Resource Planning (ERP) systems – the lifeblood of any decent-sized retail organization.

Merkur offers a number of different services around document delivery such as fax automation, sales orders, and accounts payable processing.

Integration with existing enterprise toolsets is not cheap, usually requiring services work to complete the installation. Merkur therefore has lower margins than the internet side of the business.

Financial Results

Overall, revenues were up 8% in 2010 to $9.3m compared to $8.6m in 2009, with the majority of the increase driven by Edict Systems.

Edict Systems showed strong growth among its various product lines, with the Grocery and Automotive products seeing 11% increases respectively compared to 2009.

Fourth quarter results were down slightly from the 3rd quarter, but the company has still managed an impressive track record of sequential growth:

The Merkur Group managed to squeak out a 2% sales increase.

Despite a rough showing in the first quarter of the year (sales were down $140k from the same quarter in 2009), the Merkur segment showed 3 consecutive QoQ revenue increases to finish out the year.

The company has set a target of 20% pre-tax margins across the business units. Combined, the two segments earned $2.4m in operating income, for a pre-tax margin of 25.8%.

Reported net income was $1.59m, up 33% from the $1.19m in 2009, for an annual EPS of $0.024 based on 66.7m shares outstanding.

Management

Avant-E is a closely held corporation, with the CEO and founder Jason Wadzinski owning 54.8% of shares outstanding.

He has been at the company for over 20 years, and struggled through the hard times before the company started taking off in 2003 after making the transition to the SaaS model.

In a profile last year, Wadzinski describes the challenges of growing the business and the importance of taking a long-term view.

There is no doubt that ADVC is Mr. Wadzinski’s company, but he seems to be a prudent manager and draws a very reasonable salary.

In fact, despite a record year in 2010, his annual salary actually declined from $220k to $160k.

He has already demonstrated a commitment to returning cash to shareholders by paying a special dividend last year, saying

“The purpose of the cash dividend is to reward the Company’s shareholders, many of whom have been shareholders for a very long time, and to enable them to likely take advantage of favorable Federal income tax treatment that is scheduled to expire at the end of 2010.”

Valuation

Many acquisitions in the software industry are based on a sales multiple.

As a group, stocks within the computer software sector trade for 3.4x EV/Sales ; ADVC is currently trading at a 1.3x multiple.

While some discount is warranted due to the closely held nature of the firm and small size, even a 2x multiple would translate into a fair value of $0.32, or nearly 40% upside from current prices.

Traditional metrics are low as well, with the company trading at an EV/EBIT of 5.2 and EV/FCF of 7.8.

Assigning more realistic multiples of 10x EV/EBIT and 15x/EBIT would allows room for 100% upside from the stock’s current market price.

Negatives

Software is a rapidly changing field and notoriously difficult for value investors.

There is a long list of software companies that relied on once-promising technology only to be quickly obsolete when faced with an upstart competitor with a new twist.

In addition, the company’s founder, Jason Wadzinski, controls ADVC without a group of independent directors assigned to look after shareholders’ interests.

Theoretically, large insider ownership helps align interests, but this is an extreme case where the CEO holds most of the power and could make decisions at odds with the best interest of minority holders.

Conclusion

Advant-E is a stock that has effectively captured a nice market niche, and an example of the powerful economics and attractiveness of software companies.

Average ROE of 30% and CROIC of 65% show-off the tremendous power of a well-run software company, and the stock currently has a FCF yield over 10%.

Despite these phenomenal numbers, the stock should still appeal to value investors looking for a solid business at a low price.

ADVC boasts over 4000 customers, and the business does not show any signs of slowing down.

The latest press release hits on some of the high points from 2010:

• Edict Systems revenue increased for the tenth consecutive year
• Net income exceeded $1 million for fourth consecutive year
• 2010 marked the eighth consecutive year the company has reported a net profit
• Exceeded goal of 20% pre-tax profitability in 6 out of last 7 years

Looking into 2011, the company is making an investment in upgrading its Web EDI platform to add superior functionality and greater customer value, which could temporarily depress earnings during the migration period.

Although this initiative might depress earnings over the next few quarters, it is another example of making investments with the eye towards the future.

The company now sits on $2.9m in cash offset by no outstanding debt. Hopefully management can find a way to continue re-investing that cash into the business at attractive rates of return.

Although as a shareholder, I wouldn’t complain about another special dividend!

Disclosure

Long ADVC

Electronic Systems Technology (ELST.OB) is the maker of the ESTeem line of wireless modems.

It has been a public company since 1984, and filed several patents (since expired) around wireless modem technology.

The company has built a nice cash pile on the balance sheet, and continues to trade at a discount to book value and only slightly above net cash despite being profitable in 8 out of the last 10 years.

Financial Overview

ELST reported results for the 2010 fourth quarter and full year. Annual revenues were up 18%, to $2.24m from $1.89m in 2009.

Sales dropped sharply during the 2008/2009 recession – they are still down 26% from the 2007 high water mark – but are showing signs of improvement across all product lines and geographic regions.

The domestic business increased 20% to $1.68m, and continues to make up roughly 3/4 of total sales.

Foreign revenues increased 17% at a much higher operating margin (42% margins vs. 16.5% for the domestic side).

Mobile data computer terminals (MDC) applications are marketed to public safety agencies such as police stations and now make up only 5% of total sales. The company is shifting its product mix towards more industrial automation projects, both domestic and internationally.

ELST’s strategy is to maintain low levels of inventory to provide maximum cash liquidity, as the company’s products do not require much lead time. The latest inventory balance of $421k is the lowest in the last ten years – hopefully this shows that management is prudently monitoring the available inventory.

Operating expenses increased slightly to $1.18m from $1.09m due to higher bad debt expense, professional services, and salaries. The company expects to cautiously lift wage reductions put in place in 2008/2009 due to improved revenues and profitability.

Operating profits came in at $174k, up from a slight loss last year.

Net income was $129k, up 437% from 2009, albeit from a very low comparable. EPS was $0.03.

Business Ratios

ROE was 4.18%, a number that is depressed due to the large cash balance sitting on the company’s balance sheet.

There are many different methods for calculating excess cash, but I use this formula:

Excess Cash = Total Cash – MAX (0, Current Liabilities-Current Assets)

While most companies need to keep cash on the balance sheet for day-to-day operations, it is probably a nominal amount for ELST – capex requirements are very low and the company does not keep a large amount of inventory on-hand.

Since the company has so much excess cash, ROIC and CROIC provide a better picture, coming in at 25.84% and 31.10% in 2010 respectively.

5-year average ROIC and CROIC are 17.16% and 33.41%.

ELST’s business is definitely in a niche market with capped upside, but it appears that the company remains a solid choice within this niche.

Excess Cash

Unfortunately, the large cash balance is earning very low returns due to the current interest rate environment.

The company paid a small dividend from 2003-2008, so that is the most likely course of action – the current cash balance is the highest in the last ten years.

Paying a small dividend would at least serve to return some of this excess cash to shareholders.

Valuation

On an asset basis, there is no doubt that the company remains cheap. Market cap is currently $2.8m, meaning the company is selling at a discount to its working capital.

NCAV is $0.57 per share, while NNWC is $0.54. At these prices, you are basically picking up a profitable business for free.

With the stock price at $0.55, current EV/EBIT is 1.3x and EV/FCF is 1.5x, or 1.85x and 1.65x using the 5-year average EBIT and FCF numbers.

Conclusion

While still cheap, the stock has appreciated since my original entry point. The biggest risks are product obsolescence or increased competition, as the world of technology can change very rapidly.

The company is certainly not in hyper-growth mode, as 2010 sales numbers were roughly even with 2004.

If the business is in a steady decline (meaning management cannot open up new markets), then the most important consideration is what will happen to the cash balance.

Unless management can find ways to re-invest the capital into the business at acceptable rates of returns – which does not appear to be the case – then excess cash should be returned to shareholders.

More likely, another way to unlock value would be at the hands of an acquirer. The company’s president, T.L. Kirchner, founded the company in 1984 and is now in his early 60’s.

The cash balance would be very attractive in any deal, but the question remains is the ELST’s niche worth pursuing by a larger company? Or is Kirchner thinking about parting with his legacy?

Not sure, but I think I’ll hold to see what happens.

Disclosure

Long ELST

As usual, a few of the best value investing links from the past two weeks:

Northern Oil & Gas (NGO)

Short. Northern Oil is an energy company that owns acreage in the red-hot Bakken Shale oil play in N. Dakota and Montana. The oil is recovered using a relatively new ‘fracking’ technique, where the rock is drilled horizontally and fractured, letting the oil seep out.

Oil & gas companies are generally outside of my circle of competence – one reason is the discretion associated with some accounting aspects.

NGO is finding a ton of oil, but according to the author, is accounting for depletion reserves in a different manner compared to other companies in the region.

If the depletion expense is accounted for like NGO’s competitors, the company would earn after-tax income of $3.3m – for a $1.7B market cap company!

See other articles here and here.

Syms Corp (SYMS)

Long. Syms is an off-price retailer currently selling at only 1/2 of book value. The company recently made a decent-size acquisition and is starting to benefit from synergies and cost restructurings.

The company is also sitting on a ton of real estate holdings, many of which are being carried on the balance sheet at a price much lower than market value.

One of their stores sits right in the middle of Manhattan in New York City, and the company even owns the air rights above the building to potentially expand.

SYMS has been the target of activist investors in the past, but it appears like management is prudently and deliberately trying to monetize some of these assets on their own terms – the CEO’s response letter to the activists is a must read.

Hollywood Media Corp (HOLL)

Work-out. Hollywood Media is a stock that has decided to liquidate and return cash to shareholders, and is now selling off the existing business lines.

The Broadway Ticketing division was sold in Q3 last year, and the company announced a tender offer for $2.05 per share. After repurchasing 8m shares (and refusing 16m more), the stock price declined sharply, as investors looking for a quick profit moved on to other opportunities.

HOLL is in the process of selling it’s MovieTickets.com business, a potential catalyst that would simplify the balance sheet and help close the discount to the calculated liquidation value.

Centrix Bank & Trust (CXBT.PK)

While the purpose of Weekend Values is to showcase write-ups on other sites, I’m going to make an exception and point out an excellent primer and introduction to bank investing from a recent guest post.

Banks are outside of my normal circle of competence, but they do offer the opportunity for outstanding returns, but only if an investor is performing careful due diligence.

While this write-up isn’t a short or long recommendation, it does show the type of analysis required when looking at these institutions.

My favorite quote regarding investing in banks:

“So we have a huge number of stocks that few people are analyzing or investing in, that are also cyclical, complex, boring, illiquid, and obscure.”

Read Part 2 as well.

Suggestions

If you have suggestions for detailed analysis examples from other value investors, please drop me a line using the Contact Form.

I’m always open to ideas from other investors, especially for a thoughtful and well-researched investment articles.

Disclosure

No positions.