The world has never especially loved middlemen, but it has never found a way to get on without them. In the business world, distributors of IT products like Synnex (NYSE:SNX) have long had to deal with razor-thin margins, ample competition, high working-capital needs and the threat that its customers and suppliers would work together to work around them. Although Synnex has all of these challenges, the company is doing well in growing margins and expanding its non-distribution business.

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A Good Close to the End
There are plenty of worries about the IT space these days, and warnings from companies like Juniper Networks (NYSE:JNPR) and Oracle (Nasdaq:ORCL) are doing little to help matters. When it comes to actually moving product, though, Synnex saw a very good fourth quarter.

Revenue rose 15% this quarter, with in-line growth from the large distribution business and 62% growth in the company's business services operations. Gross margin improved significantly (up almost a full point) and this drove nice bottom-line outperformance.

Operating income rose more 30%, with distribution income up almost 29% and services income up 140%. To give an idea of the dichotomy between these two businesses, consider the following: business services contributes less than 2% of revenue, but more than 4% of operating income. Admittedly, that's almost small enough to be a rounding error, but it highlights some growth potential. (To know more about income statements, read Understanding The Income Statement.)

An HP Puzzle
If an investor looks at the performance of Hewlett-Packard (NYSE:HPQ) recently, it wouldn't seem that having a major relationship with the company would be such a good thing for Synnex. And yet, while the company gets about one-third of its revenue from HP products, this has not yet been a big problem. Certainly, it helps that Synnex also distributes products from companies like International Business Machine (NYSE:IBM), Intel (Nasdaq:INTC) and many others.

Coupling a Brutal Business with a Growth Opportunity
Simply put, IT distribution is always going to be a brutally tough business. Rivals like Ingram Micro (NYSE:IM) and Tech Data (Nasdaq:TECD) have the advantage of scale on Synnex and this is a business where scale really matters.

Synnex is not without its own qualities, though. For starters, the company has a very good IT system of its own and that helps better manage working capital. Synnex also has a services business that handles functions like call centers, customer management, back office processing and supply chain management.

Not only are these higher-margin service offerings, but they help customer stickiness. A company may well consider switching from Synnex to Ingram Micro or Avnet (NYSE:AVT) to save money, but when these companies also hande business-critical functions it makes them harder to replace. Moreover, this is a market where companies that offer cost savings are going to be in an especially good position.

The Bottom Line
Synnex, like many distributors, does not have an especially good or consistent track record when it comes to free cash flow production. The growth of the services business could help change that, but it remains a difficult thing to model at this point. On a net operating profit after tax basis and the assumption of low/mid-single digit growth, the stock should trade in the very high $30s.

For better or worse, these stocks are often valued on a relative basis, with enterprise multiple being as good of a metric as any. Although Synnex trades at a premium to Ingram Micro and Tech Data, the difference in returns on capital suggest that premium is entirely justified (if not arguably too small). Considering past multiples, Synnex could still have 15-25% appreciation potential from here, so long as the macro IT environment holds up. (For additional reading, check out 5 Must-Have Metrics For Value Investors.)

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At the time of writing, Stephen D. Simpson did not own shares in any of the companies mentioned in this article.

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