Sunday, December 30, 2007

A Look at Abatix Corp.

Abatix Corp. "markets and distributes personal protection and safety equipment and durable and nondurable supplies predominantly to the environmental industry, the industrial safety industry and, combined with tools and tool supplies, to the construction industry." (hat tip to Chris) It is a fairly simple distribution business, and it is a micro-cap stock with a market capitalization of 11.97 million. The company is heavily owned by management (49.2%) and recently de-listed to save the costs of Sarbanes-Oxley regulation, but still reports quarterly financial results for its shareholders. On first glance, there are two things that make an investment in Abatix seem attractive.

First, the company's stock offers a very nice earnings yield. In 2006, the company had net income of $998,000. The company is well ahead of last year so far, with earnings of $995,000 for the first three quarters of 2007. This translates into a 10% earnings yield. There is also a bonus: the company incurred $135,000 in Sarbanes-Oxley costs in 2006 and I estimate at least $200,000 for 2007. These additional expenses will now be gone because the company has de-listed, providing a boost to future earnings.

Second, the company is trading only slightly above its Net Current Asset Value ("NCAV"). As a quick lesson, NCAV was one of Benjamin Graham's favorite measures. It is defined as current assets minus total liabilities. Because current assets are expected to be converted into cash within a year, the NCAV was essentially what the company would be worth if it was liquidated immediately. Of course some adjustments had to be made because things like inventories might not always fetch full value. But when a company could be bought for meaningfully below its NCAV, that represented a great investment. In Abatix's case, the stock is approximately equal to NCAV, meaning if the company stopped operations tomorrow, there would be a safety net for shareholders at approximately today's price. Considering that the company is meaningfully profitable at the moment, this seems like a very low-risk investment proposition.

However, I always recommend looking at a multi-year history of a company and charting some key figures. And looking at the data for Abatix going back to 1996 raises some concerns.

First is the most obvious: although sales have doubled since 1996, profitability has stagnated. The company has been unable to increase earnings or show any consistency over the long term. This isn't surprising, as Abatix is a small player with no competitive advantages, and it operates a business with very minimal expertise and start-up costs. Thus, any increase in earnings will likely be temporary as competition drives down returns.

Second, rather than generating cash flow, the company's earnings have flowed almost entirely into more inventories and accounts receivables. We can see this by taking a historic look at "NCAV - cash". In this situation, since the company has minimal long-term liabilities, NCAV is essentially the same thing as working capital. Since the company does not pay dividends, does not buy back stock, and has minimal capital expenditure expenses, we would expect to see a large cash pile being built up over the years. Instead, we've seen inventories and accounts receivables skyrocket. Thus, the business requires more and more invested capital, in the form of inventories and accounts recievables, just to generate the same earnings as before. This problem is magnified by the shaky quality of both of these assets. At the end of 2006, the company had $9.2 million in accounts receivables and $9.7 million in inventories. For accounts receivables, the company has provisioned $731,000 for bad debts, or 8% of its receivables. For inventories, over the last three years the company has provisioned $165,000, $252,000, and $151,000 for obsolescence. These are both very large numbers and they raise doubts about the safety-net that NCAV will provide in this situation.

Finally, management does not seem to be working in shareholder's interests. The top 3 executives of the company own 49.2%. This large ownership can work in two ways. They can act in shareholder's interests, realizing it is the ethically correct thing to do and that they will still receive half of the benefits because of their shares. Or they can go the second route, and abuse their power to pay themselves exorbiant wages at the expense of their shareholder's interests. A look at management's pay shows that they have chosen the latter route. Over the years, executive pay has steadily increased even as company income has essentially gone no where. Over the past 5 years, the average earnings for the company was $726,600 per year. Over the same period, the top 3 executives took an average of $665,400 in yearly pay. That is a very large chunk of shareholder's earnings going towards their compensation.

So, this began with an idea that seemed simple and looked great from traditional value metrics. But the company has no moat; earnings were coming in the form of inventories and accounts receivables, rather than cold hard cash; and management has put their self-interests ahead of their shareholders. An investment in Abatix may still very well be a low-risk proposition, but these factors are enough to dissuade me from making this purchase.

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