Advant-e released strong third quarter results yesterday. Revenues rose 5.3% from last year and net income rose 22.1%. Earnings for the four trailing quarters rose to $1.93 million, a record. The company’s cash on hand now tallies $5.11 million. Advant-e now sports a trailing P/E of 9.2 and an Enterprise Value/EBIT ratio of 4.4. Advant-e remains cheap, growing and over-capitalized. The company’s Edict Systems subsidiary has momentum behind it and gross and operating margins are hitting new highs.
Just as the company’s future looks brighter than ever, management has chosen to give small shareholders the boot. On Monday the company revealed plans to execute a 1 for 10,000 reverse split and cash out investors owning fewer than 10,000 shares at 27 cents per share. Following the reverse split, Advant-e will execute a 100 for 1 forward split and deregister its shares. Approval of the reverse split is a foregone conclusion, given CEO Jason K. Wadzinski’s ownership of 54.8% of shares outstanding. Following the split, Advant-e will cease reporting to the SEC.
In its 8-k filing describing the transaction, Advant-e does not detail the process it used to arrive at the 27 cents per share valuation. Often in the case of reverse splits, companies will hire a third party advisor to place a value on shares to be cashed out. The motivation is to avoid accusations of abusing small shareholders with a low-ball offer. The cash out price is usually set at a material premium to market price. Small Advant-e shareholders will not receive a material premium. The 27 cents per share represents only a 4.1% premium to the 30 day average trading price and a 7.9% premium to the average trading price. Less than two months ago, Advant-e traded up to 28 cents. The company plans to release a 14c statement describing the terms of the reverse split. It will be telling to see how the company determined such a paltry price to be fair to small shareholders.
I don’t call the price “paltry” lightly. A simple examination of the company’s financial results reveals how inadequate a sum of 27 cents per share is.
Growth and Earnings – Advant-e has grown its revenues at 9.5% annually since 2007. Earnings have grown by 18.5% annually over the same period. The company’s trailing net income of $1.93 million is 2.9 cents per share. Annualizing the latest quarter’s results yields earnings per share of 3.3 cents.
Free Cash Flow – The company’s free cash flow generation has been exceptional. Since 2007, free cash flow has been positive each year and has exceeded total net income by $0.53 million. Advant-e turned an amazing 17.1% of revenues into free cash flow in the period.
Capitalization – Advant-e has $5.11 million in cash on its balance sheet against zero debt. This cash amounts to 28.6% of the company’s market cap, or 7.7 cents per share. Assuming the company can operate normally with a current ratio of 2.0 (and nearly every company can) at least $3.85 million of this cash is excess, or 5.8 cents per share.
So, what is a growing company with 3.3 cents per share in annual earnings and 5.8 cents per share in excess cash worth? First, let’s assume that Advant-e’s growth immediately slows to 3% annually and remains there indefinitely. Second, let’s assume the company has a cost of equity of 15% given its small size and limited liquidity. Finance theory provides a formula for the present value of a company with a consistent rate of growth and cost of equity: next year’s earnings, divided by the cost of equity less the growth rate.
Under these assumptions, the present value of Advant-e’s earnings is $0.283. From there we can add excess cash to arrive at a full value per share of $0.341. This value is 26% higher than the company’s 27 cent reverse split value. And this valuation is extremely conservative. If the company can grow at 4% and the cost of equity is 12% rather than 15%, a share of Advant-e is worth $0.487, 80% more than the company’s offer.
In the November 5 8-k filing, CEO Jason W. Wadzinski characterizes the reverse split as a positive for smaller investors, saying the reverse split provides liquidity for smaller investors not wanting to continue holding shares in a non-reporting company. Mr. Wadzinksi goes on to say:
“We became a public company in 2000 to raise capital to help us complete our transition from a software provider to an Internet-based supply chain services provider. We are very grateful to our investors who risked their capital to enable us to execute our business plan.”
Translation: “You took a big risk in investing in us when we were much smaller and barely profitable. Now that we are bigger and more profitable than ever, I want my company back. Kindly accept this token payment for your shares and go.”
Mr. Wadzinski’s control over Advant-e will be solidified via the reverse split, and by the $2 million worth of shares the company plans to purchase in advance of the reverse split. Between the reverse split and the share repurchase, the company can expect to retire around 8.7 million shares at 27 cents. Mr. Wadzinski’s stake will rise from 54.8% to about 63%.
Smaller shareholders’ prospects of receiving fair value for their shares have not vanished entirely . Based on my readings of Delaware corporate law and related case law (and fair warning, I am NOT a lawyer) it appears that shareholders who are to have their shares canceled by a reverse split may exercise dissenters’ rights and receive an appraisal in Delaware chancery court. However, this process involves sending letters to the company notifying them of the investor’s wish to exercise these rights, providing proof of ownership, then waiting for the legal system to work. Even if the courts settled on a valuation of 50 cents per share, the investor would see a maximum benefit of $2,300 if a full 9,999 of their shares were to be canceled. While some investors might time the time and effort worthwhile, I suspect many more will simply accept the terms and move on.
An account I manage has a small position in Advant-e shares. Small enough that the entire position will be canceled in the reverse split. I am interested in hearing from other investors who have gone through a similar situation and what (if any) strategies may be employed to improve the chances of receiving fair value for these shares, beyond exercising dissenters’ rights.