Description

Executive Summary

I believe Acco Brands (ACCO - $7.34/share), a manufacturer and supplier of branded office products and computer accessories, represents a compelling short opportunity.  While the Company appears to trade at relatively low multiples of leveraged free cash flow and EBITDA at 5.7x and 6.0x 2013E, respectively, ACCO sits squarely in the crosshairs of several trends that should lead to a materially smaller business over time.  Coupled with 3.5x of financial leverage on a net debt / EBITDA basis and tremendous operating leverage with gross margins near 30% and operating margins at 10%, I believe investors are missing how precarious of a position ACCO is in.  Very small changes in their end markets, which have largely been negative over the past 6 – 7 years, will have very negative impacts on their free cash flow.  Despite the long history of industry declines and increasing headwinds, analysts remain optimistic with their forecasts.  I believe the biggest risks to ACCO’s business and stock going forward are as follows:

• ACCO’s end markets are largely in secular decline.  Office product sales have been declining largely since 2007,  supporting the view that greater use of technology and less printing generally have been hurting the office products space
• Office Depot and Office Max have announced a merger.  Consolidation in the industry should allow Acco’s customers to streamline inventory and close stores leading to lower sales volumes.  Additionally, as more of the industry sales are through fewer players (office supply stores, Amazon, drug stores, Wal-Mart), pricing pressure on Acco should increase
• Private label is a key focus for many of Acco’s customers.  While Acco produces private label products for their customers, what does this say about their business or their ability to get a price premium for their brands?  In fact, their office supply superstore customers have a stated goal of increasing private label penetration and directly sourcing products from China (bypassing Acco altogether)
• Acco’s Computer Products segment, which represents ~9% of sales and ~16% of pre-corporate EBIT is driven largely by the PC end-market.  PCs appear to be in secular decline, and because this is Acco’s most profitable segment, the impacts to their bottom line could be much more severe than many think
• Acco’s current year free cash flow and revenue are benefitting from one-time savings and synergies related to their merger with MeadWestvaco’s Office Products business.  While these benefits are real, they mask the underlying deterioration in Acco’s business.

I believe continued weakness in Acco’s results and missing earnings guidance over the next 6 – 12 months will make it clear the earnings power of the business is materially lower.  While it does trade at a relatively low current multiple (although a more reasonable 9.4x unleveraged FCF multiple), I believe in market environments like the one we are in, lower multiple stocks in secular decline make for some of the best shorts.  I believe a more appropriate value for ACCO is approximately $3/share, or nearly 59% below the current share price.

Business Overview

Acco Brands is one of the largest suppliers of branded school products and office supplies, with industry leading brands including Day-Timer, Five Star, GBC, Swingline, and Wilson Jones.  (Part of me just chuckled as I typed that, because aside from Swingline, which was made famous by the movie Office Space, how many of you have actually used these brands or still intend to use them going forward?  The business description alone could be the short thesis here…)  The Company was originally spun out of Fortune Brands in 2005 and more recently merged with the MeadWestvaco Office Products business in May 2012.  The Company sells its products primarily in the United States (~55% of 2010 pro forma sales), and Europe (~16% of 2010 pro forma sales) and largely through commercial customers (32% of 2010 pro forma sales), office supply superstores (26% of 2010 pro forma sales) and the retail/mass channel (30% of 2010 pro forma sales).  In addition to producing products under the brand names listed above, Acco produces private label products for some of its customers, in direct competition with the brands they are trying to sell.  A summary of Acco’s geographic breakdown and product categories are listed below.

It is worth noting a few things.  First, with respect to their geographic breakdown, the US still has a weak economy and Europe is in recession.  Additionally, many people believe Canada and Australia are the next bubbles to burst.  Collectively, that is 87% of their business that isn’t exactly growing gangbusters.  Secondly, in the graphic above on product categories, almost every single category is at risk of continued conversion to an electronic replacement.  As users continue to print less and consume more electronic media in the work setting, consumption of Acco’s products should decrease, and this has already been happening over the last several years.  At the very least, none of the categories and products above truly need to be branded products.  I don’t think people get excited about their Acco folders or ring binders.  Not surprisingly, these headwinds have manifested themselves in Acco’s organic revenue growth, excluding currency, over the past several years:

Despite the continued weakness in core sales, which have averaged -6.5% annually the past 6 years, analysts continue to project growth in 2013 and beyond.  Finally, it is worth mentioning Acco’s stated strategy:

Excerpt from 2010 10-K:  “Our strategy centers on a combination of growing sales and market share and generating acceptable profitability and returns. Specifically, we have substantially reduced our operating expenses and seek to leverage our platform for organic growth through greater consumer understanding, product innovation, marketing and merchandising, disciplined category expansion including broader product penetration and possible strategic transactions and continued cost realignment.”

Excerpt from 2012 10-K: “We believe our leading product positions provide the scale to enable us to invest in product innovation and drive growth across our product categories. In addition, the expertise we use to satisfy the exacting technical specifications of our more demanding commercial customers is in many instances the basis for expanding our innovations to consumer products. We plan to grow via a strategy of organic growth supplemented by acquisitions that can leverage our existing business.”

Does that really sound like a strategy to anyone?  Who doesn’t want to grow organically or generate “acceptable profitability and returns?”  I highlight this not to knock management, but to demonstrate just how much Acco is really just a slave to bigger trends in the office supply industry.  Because of this, let’s focus on the industry drivers that are affecting Acco.

Secular Weakness in Office Supplies

While the Big 3 office supply companies of Staples, Office Max and Office Depot do not constitute the entire industry, their sales trends do provide insight into the difficult environment for office supplies.  While some would argue that office supplies are simply in a cyclical downturn, I believe the numbers paint a very different story.  Below are the comparable store sales and total sales for the “Big 3” over a few relevant time periods.  While the fiscal years do not match up exactly for all three companies, the general trends would not be material if I had attempted to adjust for that.

It is important to note that even in 2006, office supply companies were barely growing same store sales.  Additionally, in the “recovery” since 2009, the Big 3 have grown total sales, including International, at a negative 1.1% CAGR.  Struggling to make material profit margins, the Big 3 have also started to cut back on stores.  What used to be a 3-4% comp sales growth plus 6% square footage growth story has largely morphed into a rationalization strategy where costs are the focus, underperforming stores are closed, and the businesses largely hope to keep cash flow constant.

Against this backdrop, it seems very difficult for Acco to grow organically (their stated goal…).  As it has become clear that end markets are not growing, less profitable customers (Big 3) that are looking for more and more ways to squeeze costs out of the system need to look no further than their suppliers (Acco).  For Acco specifically, entire categories such as Time Management and other low-tech products should be declining for good, suggesting Acco’s underlying organic growth could be even worse than broader office supply trends.

Industry Consolidation and Concentration of Sales

In response to a weaker office supply environment and some company specific missteps, Office Max and Office Depot announced a merger of equals in February 2013.  The two companies expect between $400mm and $600mm in annual synergies, driven by “purchasing efficiencies, supply chain, advertising, headcount reduction & other G&A.”  While not all of the synergies will come out of Acco’s pocket, purchasing efficiencies and supply chain savings seem to directly impact the business.  Acco currently has roughly 14% of sales with ODP and OMX combined, but on a recent conference call, they suggested only 5% of the business would be affected.

“We do think there will be a -- some impact on our US business. We don't think it will be an impact on our international business because of the lack of overlap between OfficeMax and Office Depot in our international entities. In the US, we think that about 5% of our total business is the retail overlap between OfficeMax and Office Depot. And we do think that as a result of the merger, if and when that happens, they will close some stores. So there will be a -- some destocking that will happen as a result of that. It's more of a one-time shift in nature for us, because the underlying end-user demand is not going to change. It's just how they will be fulfilled, where the demand will change probably away from Office Depot, OfficeMax, into some -- potentially some other channels. So we are preparing for some destocking, and we are preparing for them leveraging their incremental volume for a little bit of extra margin for us…We don't think it will be a big effect in 2013. There may be a little bit from just a stocking perspective, but not big. We think more of the effect will be felt in 2014.” – Boris Elisman – ACCO CEO – 04/26/13

Interestingly, Newell Rubbermaid, which sells Sharpie branded writing tools, echoed similar, if not more negative, comments on their latest conference call.  It is worth noting that historically Sharpie has grown faster than Acco’s brands, likely because of a better brand and the more consumable nature of their products relative to Acco’s.

“Finally, the consolidation of the US office superstore channel is likely to be an overhang on the US Writing business for some time to come. We expect a pretty significant liquidation of retailer inventory to occur shortly after the Office Depot and OfficeMax deal closes. We intend to proactively manage down inventories after the back-to-school merchandising window, so that we're not long with them prior to their deal closing. This planning approach will help us avoid tough conversations and expensive discounting, as they consolidate distribution networks. This certainly means a less significant back-to-school replenishment season for us in September than last year, but likely, a better consumption-driven selling flow in early Q4. Our total Company outlook assumes a no to slow growth year in 2013 on the Writing segment, and then a return to greater growth in 2014.” – Michael Polk –NWL CEO – 05/03/13

While it is difficult to quantify exactly what the impact will be, this is yet another headwind facing Acco in 2014 and beyond.  Additionally, part of the rationale for the ODP/OMX merger is to compete more effectively with Amazon, Target, and Wal-Mart.  As more of the industry sales are centered around larger and larger companies, they will have more leverage over suppliers such as Acco.

Shift to Private Label

As already discussed above, I believe few of Acco’s products have meaningful brand power and as a result, they do not deserve premium pricing.  This has not been lost on their customers, as most are quite vocal about their plans to source more directly from China and sell more of their own brands.  Private brand products are not only 10-15% cheaper for the end customer, but they provide higher gross margins on average than national brands.  I believe these savings largely come out of Acco and other branded office product suppliers.  This is best seen in Staples’ results, as they highlight their sales from private label in their MD&A.

So, while Staples overall sales have barely grown, their private brand sales are growing at an 8.6% 2-year CAGR and their branded sales are shrinking.  In its 2010 10-K, Staples stated that their “long-term goal is to grow own brand products to more than 30% of total product sales.”  Staples is Acco’s largest customer.  This trend certainly doesn’t bode well for Acco’s growth or pricing going forward.  It is also worth looking at how much operating profit is being generated by the Big 3, and ODP/OMX in particular relative to Acco.

If the combination of ODP and OMX is not making as much in profit DOLLARS as Acco, why won’t they push Acco for more?  Even prior to the announced merger, ODP, in response to activist comments, published a presentation in November 2012, filed in an 8-K on November 9^th, 2012.  I recommend readers view slides 5, and 15 in particular.  Here are a couple highlights:

• “Global gross margin improvement of approximately $100mm from a reduction in Cost of Goods sold, and our own brand and direct import growth” – Slide 5, 8K – 11/9/12
• “Developed a strategy to be significantly more aggressive increasing own brand and direct import penetration going forward in both North American Retail and Business Solutions.” – Slide 15, 8K – 11/9/12

Private label penetration can really only be bad for Acco.  If they help produce more private label products for their customers, they will be forced to take lower prices and lower margins and essentially validate that their brand has little to no value.  If they choose to compete, they likely will be bypassed as their customers will source product directly and they will lose significant market share.  Finally, if they choose to compete on price, margins will suffer and their brand will have deteriorated in value.  I believe it will be very difficult for Acco to generate positive pricing in an environment where their largest customers are actively discussing how to compete against them or source products away from them.  While this has been a trend that has developed over the past several years, the merger of ODP and OMX and continued weakness in sales should accelerate this.  At the very least, negative mix from a switch to private label should impact Acco’s business and lead to substantially lower margins over time.

Computer Products Segment

In order to achieve positive organic growth, Acco will have to overcome the headwind of their Computer Products segment.  This segment sells accessories for laptops, desktops and mobile phones and represents roughly 9% of sales and 16% of pre-corporate operating profit.  This is the Company’s highest margin segment.  What is less well-understood, is that roughly 2/3 of this business is related to the PC market, which continues to suffer a slowdown.  While the tablet and mobile phone category is growing nicely, it is unable to offset the shrinkage of the PC products business.  Additionally, Acco recently lost a royalty stream on their security business, Kensington.  Generally speaking, selling computer products and mobile phone accessories is a competitive business, and they are again selling to much larger customers that are struggling themselves.  In Q1, adjusted for the loss of royalty revenue, Acco’s computer products business declined 9.4%.  Assuming this higher margin segment continues to erode at a similar pace for the next few years as PC sales normalize, this is yet another headwind for Acco to overcome.

Core Business Deteriorating

While the business is currently benefiting from revenue and cost synergies and productivity improvements related to the recent merger with MeadWestvaco, I believe this masks the underlying deterioration in their business.  There is no doubt these savings will help 2013 and will be in Acco’s go-forward cost and revenue base.  However, if the core business is declining, how will they meet organic growth goals going forward?  These productivity initiatives are made up of hundreds of projects and are part of a renewed effort to take costs out of the business.  While they expect continued productivity in future years, I expect the pace of savings to decline.  For the current year, I believe productivity savings are masking an approximately 7% decline in core EBITDA (assuming they achieve flat sales, or 3% YoY growth in the next nine months).

Valuation

Acco is highly leveraged to small changes in both volume and pricing.  The Company has had an average sales decline of 6.5% annually for the past several years, and continued declines should quickly hurt earnings and leveraged free cash flow as the Company has roughly 3.5x LTM Debt / EBITDA.  Before I get to key assumptions used, it is important to recap all the factors affecting Acco’s business:

• Long-term secular declining end-markets with exposure to longer term trends of declining printing
• Consolidating customers and a concentration of sales in larger organizations with buying power
• No real brand power and vocal customers looking to source products directly and grow private label brands
• Exposure to PC end-markets that are in decline
• Financial and operating leverage

But, don’t take my word for it.  Here are a few of the risk factors in Acco’s recent 10-K:

“The office products industry is characterized by a small number of major customers, principally office products superstores (which combine contract stationers, retail and mail order), office products resellers and mass merchandisers. A relatively limited number of customers account for a large percentage of our total net sales. Our top ten customers accounted for 53% of our net sales for the fiscal year ended December 31, 2012….Our large customers have the ability to obtain favorable terms, to directly source their own private label products and to create and support new and competing suppliers.”

“Our customers may further consolidate, which could adversely impact our margins and sales.  Our customers have steadily consolidated over the last two decades. Recently, two of our large customers, Office Depot and Office Max, announced that they had entered into a merger agreement. While management currently expects the effects on our business of the proposed merger, if consummated, would be realized primarily in the retail channel, which only represents approximately one-third of our business with these customers, there can be no assurance that the combination of these two large customers will not adversely affect our business and results of operations. Further, if this trend continues, it is likely to result in further pricing pressures on us that could result in reduced margin and sales. Further, there can be no assurance that following consolidation large customers will continue to buy from us across different product segments or geographic regions, or at the same levels as prior to consolidation, which could negatively impact our financial results.”

“In particular, our business is likely to be affected by: (1) the decisions and actions of our major customers, including their decisions on whether to increase their purchases of private label products; (2) decisions of current and potential suppliers of competing products on whether to take advantage of low entry barriers to expand their production; and (3) the decisions of end-users of our products to expand their use of substitute products and, in particular, to shift their use of time management and planning products toward electronic and other substitutes.”

Given the mounting pressures on their business, how can ACCO maintain positive pricing and volume growth going forward?  Despite this, I believe I am being overly generous in my base case below.

Key Assumptions:

• Inflation of 1.5% annually
• Productivity savings of $12.5mm annually in 2014 and beyond (above and beyond guidance for 2013)
• Cost synergies related to the merger of $10mm incremental in 2014 (above $20mm guidance for 2013)
• No changes in FX
• CapEx equal to depreciation over projection period
• $13mm negative impact to revenue from ODP/OMX consolidation in 2014

For conservatism, I assume just 50bps of pricing declines in the base case, despite the obvious pressures.  To be honest, I don’t believe my base case.  I only point it out because even under these assumptions, the valuation for ACCO’s equity gets ugly and it is difficult to credibly argue for much better than a 3% annual revenue decline.  I’d also point out that my “bear” case actually gets to revenue growth values that are in line with the last six years, and pressures are increasing.  Even the bear case might prove to be optimistic.  For conservatism, I’ve assumed ACCO hits their guidance for flat 2013 revenue including $20mm in synergies, despite the fact that revenue declined 11.4% in Q1 2013.  Finally, it is worth noting that ACCO groups mix into their volume growth.  Thus, shifts to private label, which is one way that pricing pressure manifests itself, would show up in volume/mix.  Given that, I believe my volume estimates above are sufficiently conservative.  Here are my estimates:

What is clear is how sensitive ACCO is to small declines in revenue going forward.  The difference between the base and bear case is only 3.5% per year on the top line, but the weakness in EBITDA and FCF is significant.  In particular, if pricing weakens, it has a 100% variable margin impact to the business and profitability can decline substantially with only slight declines in pricing.  Needless to say, all of these numbers would yield significantly lower valuations.  A DCF of my base case gets to a value of $2.75 / share using a 10% discount rate and giving them credit for $100mm of NOL value.  There is no equity value in the bear case valuations.  At a 5x EBITDA multiple on 2015E numbers, today’s valuation would be ~$2.90/share.  I will be generous and round up to $3/share.  It is worth noting that Avery Denison recently sold its office products business to CCL Industries for approximately 4.5x LTM EBITDA.

In summary, I believe that industry pressures will continue to mount putting intense pressure on ACCO’s EBITDA and FCF.  This looks like a slow-motion train wreck.  Over time, this should lead to missing “street” estimates (currently $313mm and $326mm of EBITDA in 2014 and 2015 respectively), and ACCO should adjust to a more appropriate valuation for its business prospects.  In a more bearish downside scenario, Acco might have troubling servicing its debt.

• This could be lumpy.  I’m sure there will be quarters where they might actually have positive growth and every analyst will rejoice about the paper renaissance.  I think that will be short-lived.
• Leverage works both ways.  If they are able to cut materially more costs or volumes grow much better than I project, their FCF and earnings will improve materially.  Historical results suggest this is unlikely.  As a temporary fix they could materially slash advertising expense which would inflate earnings and cash flow temporarily, but would likely lead to their demise.
• They could do accretive acquisitions once their balance sheet gets cleaned up more.  Assuming they do office product acquisitions, I am less concerned.

DISCLAIMER:  The author of this posting and related persons or entities ("Author") currently holds a short position in this security. The Author makes no representation that it will continue to hold positions in the securities of the issuer. The Author is likely to buy or sell long or short securities of this issuer and makes no representation or undertaking that Author will inform the reader or anyone else prior to or after making such transactions. While the Author has tried to present facts it believes are accurate, the Author makes no representation as to the accuracy or completeness of any information contained in this note. The views expressed in this note are only the opinion of the Author.  The reader agrees not to invest based on this note and to perform his or her own due diligence and research before taking a position in securities of this issuer. Reader agrees to hold Author harmless and hereby waives any causes of action against Author related to the above note.

Catalyst

• Continuing to miss “street” estimates
• Material negative operating performance could trigger defaults on their debt covenants
• Burning cash