RealMoney Silver - A Paired Trade That Plays on Tech Spending

A Paired Trade That Plays on Tech Spending
By Bill Trent
RealMoney.com Contributor
4/2/2008 11:34 AM EDT

With razor-thin profit margins, tech distributors Ingram Micro (IM) , Tech Data (TECD) and Synnex (SNX) tend to be hit hard in spending downturns and rally just as hard when a recovery finally appears.

The tricky part is figuring out exactly when that turn will come and when the bad news becomes fully reflected in the price.

Right now, with the economy clearly slowing but the stocks already well off their highs, the task is particularly dicey. Inventories are looking lean, and orders for computer equipment have been strong. Against that backdrop, earnings estimates are still plunging, and from a technical standpoint the charts look horrible.

The catalyst that Jim Cramer is looking for may simply be the opportunity to buy on bad news. That's why I think playing both sides in a long-Ingram Micro (IM) /short-Tech Data (TECD) paired trade may make sense.

By virtue of its recovery from a disastrous 2006 (fiscal 2007), Tech Data has been the stronger name this year. Shares are down 20% from the high, compared with 30% for Ingram. Tech Data's apparent outperformance is simply due to relatively stronger results after the terrible 2006.

Looking at both companies' free cash flow yields, you might think Tech Data is the cheaper stock. While Ingram's equity is valued at a respectable 8.6% free cash flow yield, Tech Data offers a lush 18%.

However, Tech Data's cash flow has been artificially heightened by an unsustainable increase in accounts payable. Payables grew 14%, compared with a 4% rise in sales and a 9% increase in cost of sales. On an ongoing basis, free cash flow would likely be half as much -- and its yield more similar to that of Ingram.

Analysts are more bullish on Tech Data, expecting the company to post 14% annual growth over the next five years, compared with 11% for Ingram. Of course, Tech Data has easier comps, having seen its earnings decline an average of 5% per year for the last five years, while Ingram was busy racking up 25% annual gains.

While the two companies tend to take turns outperforming one another, over the last five years and since the market peak in early 2000 their cumulative performance is nearly identical. This time around, I'd expect both companies' P/E multiples to converge, perhaps to 10 times estimated 2009 earnings. To budget in the possibility of further estimate cuts, I am also using the lowest estimate on the Street.

At 10 times the Street-low estimate of $2.38, Tech Data could see a further drop of nearly 30% from current levels. Ingram, meanwhile, could see a 20% share price rise if it were to trade at 10 times the 2009 low estimate of $1.86.

Similarly, Ingram's price/book ratio is 0.79, compared with 0.95 for Tech Data. Assuming the two meet in the middle five years from now, the convergence would act as a 2%-per-year drag on Tech Data but boost Ingram by 2% annually. That's more than enough to offset the difference in expected growth rates.

I'd revert to that mean any day.