Description

This is a controlled company with a 250mm market cap, but I think the stock has at least 50% upside and is an attractive risk/reward for smaller funds and individuals.

Why is it mispriced?
Besides illiquidity and lack of coverage, Systemax is cheap because of ugly and declining consolidated results and scary headlines. Operating income from FY’10 through FY’15 was 68.7mm, 80.8mm, -39.9mm, -20.6mm, and -25.9mm. Both the change and the absolute numbers are awful and are enough to dissuade most investors who imagine the entire business is a consumer electronics distributor being destroyed by Amazon. But, parts of this business (Industrial Products) are decent. And money losing parts (Retail) are being liquidated, while break-even parts (Technology Products) have strategic value if they can’t be fixed.

This is a classic “good co”/ “bad co” setup. Insiders are aligned because they own the majority of the stock, which is important because they are incentivized not to maximize the top-line (and thus their salary) but the per share value. Though ego can get in the way of founding/controlling owners who are faced with change, management has acknowledged that the parts are worth more than the market gives them credit for. More importantly, management has taken actions to fix or get out of the bad parts. Short of management deliberately robbing minority shareholders (anecdotally, they aren’t that sort of family) or being completely inept, we should do fine.

Overview:
Until recently, Systemax operated the Technology Products B2B distribution business in North America and Europe (both reported in Technology Products segment), retail stores in North America (within the Technology Products segment), TigerDirect (online sales) and the Industrial Products distribution business in North America. On March 10th of ‘15, the company decided to exit the retail business (keeping sales to consumers via TigerDirect), whose problems can be summed up as ‘Amazon.’ Below is the capitalization and FY’14 summary results.

Sales by channel (mm):
Technology Products – EMEA -> 1,189.9
Technology Products – N.A. B2B-> 800.0
Technology Products – N.A. Consumer (50/50 retail/online) -> 891.0
Industrial Products -> 556.0
Corporate and other -> 5.9
Consolidated -> 3,442.8

Operating Income by segment(mm)*:
Technology Products -> -51.3 (-25.6mm adjusted. Note this includes EMEA, N.A. B2B, and N.A. Consumer)
Industrial Products -> 41.0
Corporate -> -15.6
Consolidated -> -25.9
*unadjusted for (lots of) special charges

Capitalization (BS on 3/31/15):
Shares -> 36.8mm
Price -> $6.80
Market Cap -> 250.4mm
Cash -> 132.9mm
Debt -> 3.1mm
EV -> 120.6mm

Valuation and Segment Details:

After cash outlays of 50-55mm (severance and lease exit costs), Systemax expects to completely exit their Retail business and improve pretax profit immediately by 20mm. With this 20mm of savings and excluding one-time and non-cash charges, I expect the Technology Products segment to be roughly break even on ~450mm less of sales going forward.

After the retail business is shut down, for an EV of 120.6mm plus 52.5mm of cash restructuring costs, you’re getting approximately 27mm of operating income (Industrial Products + Technology Products + Corporate) for '15.
The valuation looks cheap in the context of the consolidated numbers, but the sum of the parts, after considering the strategic value of the break-even parts of the business, gives a per share value of $13.20.

Industrial Products:

The Industrial Products business was started by Richard Leeds’s father and uncle in the late ‘40s. It was a door to door, catalog based business that sold material handling and other products you might see in a warehouse. Only in the past decade or so have you seen more substantial growth as the business was able to sell online and through managed sales teams.

This business sells a “wide array of industrial products and supplies categorized as Maintenance, Repair and Operations (“MRO”) which are marketed in North America and Mexico.” It operates under the Global Industrial brand (http://www.globalindustrial.com/) and offers a lower touch, and thus lower price, model versus companies like W.W. Grainger (GWW) or MSC Industrial (MSM). Businesses like W.W. Granger have more feet on the ground and in the customer’s locations and will also spend time qualifying accounts, whereas anyone with a credit card can order from the Global Industrial website. Systemax doesn’t “own” their customer, and many times the customer is a one-time buyer, e.g. someone looking to set up a warehouse, but typically once customers find Industrial Products they are drawn back because of the favorable pricing.

Over the past decade, sales have grown (mostly organically) from 151.6mm to 556mm (FY’14) and, after a recent acquisition and some growth, I expect FY ’15 sales of 700mm.

Systemax mainly competes against smaller players with ~50mm in sales. Those players typically focus on a few verticals and price equal to or in most cases higher than Systemax. Operating margins have been about ~8%, and adjusted operating profit has grown from 10.8mm to 41.4mm (FY’04-’14). I expect FY ’15 to be 48mm.

Growth has been mostly organic and I attribute it to share gains and SKU count increases. Share gains are at the expense of smaller competitors (similar to the competitor they recently acquired). SKUs have vastly increased in recent years (additional SKUs have been mostly drop shipped) and now they are looking to rationalize SKUs and concentrate on doing higher volume with fewer vendors, which should bring better pricing. The strategy of rapidly increasing SKUs was successful at drawing in new customers, some of whom stuck around when they discovered the favorable prices.

They’ve made forays into managing more of the inventory in customer locations through technology vs. stationing an employee onsite like a higher touch competitor might. There are also opportunities to add more private label SKUs, where higher margins more than make up for slower turns (and longer lead times, but these product don’t change rapidly like they do in tech). All told, they’ve been successful at growing by increasing both SKUs and customer counts, and a focus on sourcing those SKUs better (through vendor consolidation and bringing in-house items that were drop shipped) could lead to higher profits at decent returns.

In my base case valuation, I’m not factoring in operational improvements or above market growth for this business, even though both could happen. The Industrial Products business was just one piece of a larger pie in previous years : the size of - and eventually the problems in - the other businesses distracted management from making improvements here. Going forward, Industrial Products is the bulk of the value and management will be more focused on it. Near term, I expect them to focus on better forecasting tools at the DCs.

Using 48mm of Operating income less 15mm of corporate (I’ll fold in all unallocated corporate overhead here) at 7.5x gives ~250mm of value. This could end up being conservative, because if other parts of the business are sold, some corporate overhead could be taken out. Additionally, 7.5x EBIT (or 12x NOPAT) for a business that has shown good organic growth with the prospect for more could prove to be conservative (with MSM and GWW at ~50% higher EBIT multiples).

Technology Products – N.A.:

Technology Products serves both businesses and individual consumers through a wide variety of products including computers and accessories, networking, software, and a variety of CE. In the 80s Systemax got into technology distribution and related businesses. They purchased Tiger Direct in the 90s. They were seen as a smart buyer of last resort for technology assets and IP: they were the stalking horse for the Circuit City brand, IP, customer lists, etc. and they bought select assets of CompUSA when they ran into trouble. These assets did well for a while, but in hindsight they overpaid.

Consumer:

On the consumer side, the retail locations and websites compete with companies like Best Buy, hhgregg, newegg and of course Amazon. The consumer business was highly profitable five years ago but quickly declined for obvious reasons. After exiting 31 retail locations with 450mm of sales, the consumer business will only consist of the websites, which will attract less traffic but should still be profitable. I include the remaining online sales below as part of B2B.

B2B:

On the B2B side, competitors include Insight Enterprises (NSIT), CDW (CDW), and PC Connection (PCCC). This business has slightly above breakeven adjusted operating income on 800mm of sales (going to ~910mm assuming they keep 1/4th of the online sales portion of the consumer tech business).

The North American portion of Technology Products has 500 sales agents with about 50,000 managed accounts. A strategic buyer would love the sales agents and their customers and wouldn’t need the IT, back office, or probably even the warehouse. The closest I could get for what these costs amount to are “multiple tens of millions.”

Though we don’t have P&Ls for the consumer and B2B businesses within the Technology Products segment, Systemax proves a breakdown of sales between B2B and Consumer, and we also know the sales and operating profits of Technology Products EMEA business.  

If we look at just the B2B sales within Technology Products – N.A. (note that overall B2B sales in their summaries includes Industrial Products and Technology Products EMEA), sales have gone from 751mm in FY ’08 to 800mm in FY’14. Though Systemax doesn’t provide an operating profit breakdown between B2B and Consumer, I’ve backed into (and the company confirms) slight operating profits that have improved over the past few years. If you want a back of the envelope check on this take a look at the deterioration in the entire Technology Products North America business and consider that consumer sales have declined 650mm since 2010. Reasonable assumptions about operating leverage (plus assertions that op profits will improve by 20mm post retail shutdown) will show that the entire deterioration has been on the consumer side. 

Either way, I believe they will look further improve this business or sell it. In Q&A, I can get into the specific issues facing them.

I value this portion of the business on a multiple of sales. PC Mall sells for .15x sales, PC Connection sells for .24x sales, Insight Enterprises sells for .24x sales, and CDW sells for .75x sales. These aren’t perfect comps, but considering the easy cost-outs, I think .10x 910mm of sales, or 91mm, is reasonable.

Technology Products - EMEA:

All told, the European businesses have over 1b of sales and are slightly money losing on an adjusted basis. Management believes the resolution of management issues as well as completing the move (and getting rid of duplicative and transitional costs) to a lower cost shared services center in Hungary will solve their problems, but I’m not holding my breath. I could use a valuation similar to the North American business, but instead I give zero value to all of it save their operations in France. France does 3% operating margins on a 380mm topline, which at 6x is worth 70mm.

Cash:

Net cash of 129.8mm less 55mm of exit costs for N.A. Retail gives 74.8mm

SOTP:

Adding it up gets us to ~486mm, or $13.19/share.

I think about the SOTP assuming Industrial Products is run “as is” and assuming the other businesses are either fixed or sold. But, I do think the Industrial Products business would be attractive to strategic buyers when you consider the amount of corporate overhead, IT and back office expenses relative to the operating profits of the remaining business. The company has said cost outs for a strategic in this segment could be 20-30mm. NEO compensation and public company expenses alone are ~10mm.

Risks:

63% of the stock is controlled by insiders (mostly the Leeds family) who have perhaps responded too slowly to the changing dynamics affecting their businesses. They might make more mistakes, or they might take actions to capture all of the mispricing for themselves.

Value could also be destroyed if the Technology Products business gets worse and they wait before doing something about it. If you give Industrial + Corporate overhead 12x NOPAT and assume no cuts to overhead and 50mm of value destruction in Technology Products you still get some upside though. This is your margin of safety. 

Catalyst

Better results or a sale of Technology Products business. Completion of the Retail business shutdown.