Lay it on the lion

Azlan has had a hard year by anyone's standards. But following itsrecent rights issue, and the streak of investor confidence thisdemonstrated, the company's future will be tough going.

Azlan lives to trade another day. The Wokingham-based networking equipment distributor has completed its #24.2 million rights issue - which was in any case fully underwritten - injecting much needed working capital into the once-stricken company. It has also turned in a set of interims that met the revised forecast losses before tax of #7.9 million on sales up 11 per cent at #141 million.

Barrie Morgans, Azlan CEO, admits to continuing pressure on product margins and says the stock business was 'further constrained by an inappropriate stock profile and by the company's cash constraints during the period'. However, the board is 'confident that Azlan retains the support of its key vendors and its customers'.

Despite everything, Azlan has retained all the A-brand networking vendors under its belt - it must be doing something right.

So it's business as usual then, for Azlan. It was at one time a City darling, as the Mail on Sunday pointed out in September: 'Among the hardest hit will be Dresdner Kleinwort Benson, which has an 11 per cent stake.

In April, its electronics analysts, Mark Loveland, described Azlan as an undervalued low-risk play and set a target of 790p for the shares.' Dresdner Kleinwort Benson and other City shareholders were sold a pup.

To recap, in April Azlan released a statement confirming its profits were in line with expectations of #14.8 million. Instead, it eventually came in with #15 million losses. Azlan, under CEO Christian Martin and non-executive chairman Mike Brooke, was #30 million worse off than it had realised. Azlan shares were suspended at 555p in June. They eventually returned on 28 October at 49p.

In the meantime, forensic accountants from KPMG unravelled a sorry story of serious management neglect at Azlan. According to the Daily Mail in October, they found 'a lack of basic financial controls', particularly in the groups' purchasing department. In certain cases, managers also disregarded generally accepted accounting principles. The group was failing to return unwanted stock to manufacturers in time to claim a discount.

In the understatement of the year, Morgans said the nine staff who were disciplined and the three who resigned in connection with the KPMG findings were 'silly, but not fraudulent'. Morgans was equally soothing in an interview with the Daily Telegraph. 'No instances of fraud have come to light, but obviously there has been neglect on the part of some individuals.' The trio of top executives who resigned - Mike Brooke, Christian Martin and former financial director Adrian Lamb - were not personally implicated, Azlan says.

It is difficult to shed too many tears for the guys at the top. All three of them were handsomely compensated for their time in office. Brooke, for instance, earned #100,000 a year as a part-time non-executive chairman.

This fits many people's definition of fat cat. Martin and Brooke also earned millions through their entirely proper dealings in Azlan shares.

Martin waived his right to compensation when he resigned in August and has returned a #100,000 bonus he was given in May. A #25,000 bonus paid in November is said to be unrecoverable. Brooke was given #26,500 in lieu of notice. In light of the collapse in Azlan's profitability and share price over the last year, this seems a generous gesture.

If Azlan had been a US company, shareholders would have leapt to class action. There is still a theoretical chance that shareholders in the UK could sue Azlan and its former directors.

Azlan is now under new management, with Morgans at the helm and Peter Bertram financial director. Will it make a difference? Since returning to the stock market in October, Azlan shares have only risen as high as 77.5p. On 25 November, the shares were trading at 66p. Clearly, there are some investors who think Azlan is worth a punt. With shares now trading around 66p, Azlan's market capitalisation comes in at around #66 million, compared with arch-rival Ilion's capitalisation of #41.4 million on 25 November.

This is not a vote of confidence in either Ilion or in IT distributors.

Ilion shares plummeted more than 30 per cent last week after it issued a profit warning, referring to the problems of Azlan. The networking distributor says it expects pre-tax profits for the year to 31 December to be about #6 million to #6.5 million, compared with #8 million previously expected.

'The major cause of this is a fall in UK margins,' according to a company statement. 'This is largely due to exceptional market conditions caused by a major competitor with acknowledged financial problems.'

Over the summer, Azlan dumped millions of pounds of inventory on the cheap, in an attempt to restore its clearly unhealthy cash position. Other distributors reported sticky trading during Azlan's great summer sell-off. Ilion thought it could profit from Azlan's woes - even running ads carrying the tag line: 'Who is taking the lion's share?' However, Ilion showed itself quite incapable of putting the boot in.

In the summer, sterling fell three per cent against the dollar. Azlan failed to adjust its prices, so Ilion had to follow suit. Three per cent margin loss is a heavy cross to bear for any distributor, but Ilion reckons that Azlan-led margin pressure is temporary, as Azlan's inventory levels are greatly reduced.

It remains unclear whether Azlan has addressed its operational weaknesses, as exposed by the #30 million disaster presided over by Martin and Brooke.

Morgans says Azlan was sitting on #48 million of stock at the beginning of the year. This suggests a stock turn rate of four or five times the original figure - lamentable by IT distribution standards. Of course, the true figure is obscured by the level of obsolete inventory. Had the company never heard of stock rotation? 'We have driven stock down to #21 million and we have seen a fall in margins, but it is what he planned,' Morgans says. 'The inventory hasn't had the ideal profile, but unfortunately we could not bring the products into the market.'

I once dubbed Azlan the great success story of value-added distribution.

Now I am not so sure. Gross margins historically are 24 per cent, I wrote in PC Dealer, 30 July - a figure that has remained constant for years.

It has worked product lifecycles well, introducing high-ticket, high-margin items as older technologies decline into commodity status.

This has been the Azlan story for years. I recall David Randall, former Azlan chief executive, sacked in a board putsch, and Nick Coutts, then in charge of the company strategy and now worldwide head, telling me how Azlan products were de-emphasised as they moved along the product curve.

And I bought the story. I was not alone.

The trouble is, networking equipment margins have not been between 23 and 24 per cent for years. Ilion, for example, operates on five per cent net and between 13 and 14 per cent gross - a cost of sale of about eight per cent. How did Azlan manage to achieve 24 per cent gross?

Azlan's obsession with maintaining these margins may have got it into trouble in the first place. Financial controls were lacking so long as the results fitted the desired target. Granted, Azlan has a much more substantial training business than Ilion and services are the source of 50 per cent of Azlan profits. But how big is Azlan's training arm? In the UK, training runs at about #15 million turnover, while Europe - mostly Holland - could contribute as much again. At the most, Azlan Training is doing #30 million, or less than 15 per cent of group turnover.

Training contributes one quarter of all profits, but is unlikely to improve group-wide gross margins by no more than two or three points. Azlan's point about introducing high-ticket, high-margin franchises to replace commodity products looks sound. But how often do big, new profitable franchises come along?

By their nature, new franchises produce less turnover than more mature products, with few exceptions such as Ascend. So to maintain gross margins, Azlan needs to keep introducing new products, requiring extra training and administrative overhead. The alternative is to buy a substantial networking consultancy business, but Azlan can't afford to. Shareholders will not release any more funds until the company has proved it can operate its existing businesses.

Which brings us to the rights issue. Was the #24.2 million raised in the rescue rights issue enough to restore the company to good health?

The orthodox thinking on these sort of issues is to get the bad news out immediately and over-provide on everything you can think of.

This way you can release unused provisions back into the accounts over the next year or two. By adopting this sort of caution, Azlan could ensure halfway respectable results, even if underlying trading patterns are not so good. But it is not clear whether Azlan has enough money to do this. Shareholders will be keeping a very tight rein.

There are four ways that Azlan can dig itself out of its hole - trade hard, cut overheads, sell some of the company, or sell the entire company.

Azlan can trade only as hard as its suppliers will let it. I suspect the suppliers will keep credit fairly tight. Nevertheless, Azlan could obviously gain market share by heavy discounting. I expect more margin pressure in the networking distribution business.

Selling bits of the company, for example Azlan Italy or Azlan Training, has its merits. But it will undoubtedly affect the exit price when the company eventually gets sold. Azlan's future is probably best served being owned by another company. This way, shareholders get to see at least some of their funds restored and Azlan operating units won't have to worry about working capital constraints hampering growth plans.

In the meantime, Azlan needs an experienced operations/logistics director to work up the efficiencies. Compared with Ilion, Azlan is not exactly lean and mean - its European distribution centre is in York, hardly the logistics hub of the universe. As shareholders won't stump up more money, Azlan will have to take an axe to its overheads.

It has to stop thinking of itself as a high-margin services company and start operating like a distributor. This means paying attention to boring little details like inventory turns, stock rotation and the citing of logistics centres. This will be a messy business but will make Azlan more attractive for acquisition.

Morgans and Bertram will be amply rewarded for their efforts. If they can get the lion roaring again, they will be worth every penny.