Wayside Technology: Is It Cheap? – Seeking Alpha

I found Wayside Technology (WSTG) after running a stock screener for growing small-cap companies with low P/E ratios and high returns on invested capital. I think it could be a valid investment, depending on how much risk an investor is willing to take on, as well as their intended time frame. While the company looks good on paper now, there are some aspects of its business that concern me.

The business

Wayside operates under two significant segments, according to its most recent 10-K:

1.) The Lifeboat Distribution segment: distributes technical software and hardware to corporate resellers, value added resellers (VARs), consultants and systems integrators worldwide.

2.) The TechXtend segment: a value added reseller of software, hardware and services for corporations, government organizations and academic institutions in the USA and Canada.

The Lifeboat Distribution segment is by far the largest, accounting for a touch over 88% of overall sales and almost 82% of gross profit in fiscal 2016. Despite its smaller size, the TechXtend segment is more profitable at the gross level, with margins of 10.25% versus a gross profit margin of roughly only 6% for the firm's larger segment. Pretax profit margins for the latter are roughly 4% and 5.93% for the smaller segment.

Wayside also breaks out assets related to each segment in its annual report, and dividing The Lifeboat Distribution segment's pretax profits by its related assets indicates a 23% return. The smaller segments pretax return on assets is much lower at only about 9%, despite higher profitability.

The problem with the overall business is perpetually declining margins. This problem could continue indefinitely as well, as competition heats up in the e-commerce space and the trend of vendors who are selling direct to customers continues. The company is essentially a middleman, and its long-term prospects could be dim going forward.

What about the short-term?

So far, declining margins haven't inhibited the firm's return on equity in the short-term. I created a DuPont analysis in Excel using data from the firm's financial statements to illustrate what's been going on with its ROE over the last few years.

Wayside's ROE is stuck around the 15.50% mark, but as can be seen from the above DuPont, this is largely because increased asset efficiency (judging by its improved asset turnover ratio from 2014 to 2016), and the magnifying affects of leverage. EBIT margins have slipped sequentially for the last three years, and are much lower than they were a decade ago, when they sat at around 2.87%. Margins are slim to begin with, and as long as they continue to erode away, the company's shares leave me a little cold when considering it as a long-term holding.

Short-term, we have a firm that still spits out double-digit ROE (although this number has been higher, reaching nearly 20% in fiscal 2011). Despite its ROE settling around the 15% to 15.50% range over the past three years, much of this is simply because of increasing leverage, not necessarily stabilizing or even improving fundamentals.

Taking a closer look at the capital structure

The company has no advertised debt on its balance sheet, but does have some non-cancelable operating leases.

I decided to discount the leases at 5%, in order to theoretically capitalize them and inject them into Wayside's capital structure.

The company's balance sheet is still notably strong even accounting for the leases, and with this information in hand I'd like to calculate an estimate for the firm's return on invested capital next. First, we need to adjust the company's operating profit, or EBIT.

Now we can account for taxes to arrive at an adjusted net operating profit after tax (aka NOPAT) numerator, and then divide it by the adjusted capital base denominator.

Wayside's ROIC is likely about 1% to 1.5% lower than its ROE by my estimates. Due to the low capital intensity of its business, it's also likely earning economic profits. Will it still be earning these illustrious excess profits in ten years from now? I simply do not know.

Conclusion

Wayside Technology initially looked good on paper, but didn't hold up when I examined it a little closer. I still think the company is a solid operation, but as long as its margins are continuously declining and competition continues to heat up, I don't see myself considering it as a candidate for long-term investment. As a short-term investment (aka a trade), perhaps it could work for the right investor, considering its low P/E ratio in an elevated market, coupled with its 3.64% dividend yield. It's also growing the top-line at a decent clip:

WSTG Revenue (NYSE:TTM) data by YCharts

Perhaps this growth can prop up the company for awhile, but it should also be noted that this growth is backed by declining margins and weakening cash flow. Free cash flow dipped into negative territory in fiscal 2016. Looking at the past (using FastGraphs and Gurufocus.com), Wayside's P/E seems to hover around the 12x to 14x range historically, so I'm not sure it's really the bargain it appears to be on paper, either.

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Wayside Technology: Is It Cheap? - Seeking Alpha