Description

When the bargain meter is at four and you are afraid to go short, you can either sit on your hands or you can work harder. We chose to work harder, albeit we directed our efforts to a Swiss listed small cap named Amazys (stop reading right now if you think we misdirected our efforts).

Double digit EBITA margins (13.5% LTM), double digit FCF yield (12.5% LTM), growing business (17.2% in local currencies during 1H 2003), excellent mgmnt team, rock solid balance sheet (no debt and cash is equal to 15% of the market cap), 2% dividend yield, proprietary technology, strongest brand in the industry, high market share (17-20% worldwide), significant hidden asset. Simple-stupid, this is a good business trading at an enterprise value of 8.0x LTM FCF. Let’s be honest, with a 12.5% FCF yield not much should have to go right for this to be a good, maybe a great investment.

Valuation – all figures in Swiss Francs but I use $ signs in the place of the CHF designation
3.1m shares outstanding and current share price is $34.20. MktCap of $105.8, and cash is equal to $16.2m. Hidden asset in the form of a technology park that is currently listed for sale in New Windsor, New York. Local real estate listing shows that the tech park is listed for US$6m (equivalent to about CHF$8m). Based on the market cap and current cash balance, the EV is roughly $90m, or $82m if you assume the tech park is sold for its listed price (likely no capital gains on the sale). To be conservative we will ignore the hidden asset in all of our valuation and FCF figures going forward.

Over the last twelve months (LTM ended 6/30/2003) the company has generated $11.3m in FCF. This equates to an FCF yield of 12.5%. We define FCF as net income, plus depreciation/amortization, less change in net working capital, less capex. Our 2004 FCF projection is $11.7m and our 2005 FCF projection is $12.3. These FCF numbers equate to an EV/FCF multiple of 8.0x LTM, 7.7x 2004E, and 7.3 2005E.

We believe our 2004 FCF fcst is conservative based on YTD results. EBITA improved from $5.4m in 1H02 to $8.1m in 1H03. Similarly, FCF improved from $4.0m to $6.1m (NWC was -$300k in 1H03 due to sales growth, so the FCF variance is due to margin improvement rather than a one-time nwc reduction). If you put a gun to our head we would tell you 2004/05 FCF will be significantly above our fcst, but let’s move forward erring on the side of caution.

On an EBITDA basis, LTM EBITDA is $17.6m. Analysts (Vontobel and Pictet) are projecting full year 2003 EBITDA of $18.0-18.5m, and full year 2004 EBITDA of $20.1- $20.7m. As such, the company is trading at an enterprise/EBITDA multiple of 5.1x LTM, 5.0x 2003E, 4.5x 2004E. Avg capex during the past three years have been $3.2m per year. Mgmnt expects this figure to be between $2.0-4.0m going forward for each of the next three years. Capex was higher than usual during 1H 2003 due to some one-time IT expenditures and some capex to get the tech park ready for sale. EV/(EBITDA-Capex is 6.1x LTM and 5.3x our internal 2004F.

Another thing to keep in mind if you like using EBITDA multiples, is that AMSN’s tax rate is between 25-30%, as opposed to 38-40% for a US company. You should also note that the Company has about $5m in NOLs, however, to be conservative we do not give the Company any credit for these.

As for whether this is a decent business, full year LTM EBITA margins are 13.5%. With respect to asset productivity, pre-tax return on average net assets for 2002 was 30.9%. This figure will be significantly higher going forward in light of the improved margins. As you can tell from these metrics, this is a double digit margin, low capex, high ROIC business.


History
The predecessor to Gretag Macbeth (Gretag AG) was purchased in a mgnt buyout from CIBA-Geigy in June 1990. The Gretag Color Control Systems division of Gretag AG and Macbeth merged in 1997 to form GretagMacbeth Holding AG. The holding company was later renamed Amazys Holding AG in 2002.

The company went public in June 1997 and underperformed during the first couple of years due to disappointing earnings. During the go-go tech rally, former mgmnt transitioned the company to become a more software oriented venture. Ultimately the company had a few hiccups operationally and demand from endusers declined as the economy slowed. To compound the problem, costs had spiralled out of control due to R&D overruns, a product recall, and overly aggressive marketing. While a profit warning was ultimately delivered under the watch of the new CEO (who started February 2001), the damage was done under prior mgmnt.

To add insult to injury, Gretag Imaging Holding AG - a sister company which was also spun out of the MBO - went into bankruptcy last year. As a result, the MBO team behind Gretag Macbeth/Gretag Imaging has been tainted with a negative light. While none of these individuals hold mgmnt positions at AMSN, two of the individuals still sit on the Board. Alas, Gretag Macbeth changed its name to Amazys in an effort to distance itself from the Gretag Imaging bankruptcy. While the name may have changed, it would seem that a scarred Swiss investment community has not forgotten that the MBO team behind Gretag Imaging continues to be sit on the Board of AMSN. It is for this reason that we believe AMSN is a common stock that offers uncommon profits.


Overview
By employing either physical instruments (such as densitometers or spectrophotometers) or complex software, the company assists customers in measuring and controlling various facets of a product’s appearance and functionality. At the 50,000 ft level, Amazys uses its long history of color know-how and its capabilities of color science and technology to solve business problems.

Customer problems are typically centered on speed, waste, or quality. Amazys in turn provides solutions that will improve time to market, reduce waste, and ensure a consistent level of quality. The company has a very strong reputation as an innovative Swiss company with precise workmanship and attention to detail.

The Company has two divisions, Color and Appearance, and Digital Imaging.

Color and Appearance – 45% of revenue
The primary industries served are paint, plastics, textile, ink and automotive. Products help ensure color consistency throughout the entire supply chain from design and specification to the final production, resulting in shorter time to market, reduced costs and waste, and improved quality for a wide range of markets that incorporate color into the finished product, including paints, plastics, textiles and paper.

From what we understand, Datacolor (Eichhof subsidiary) is the leader in textiles, X-Rite (XRIT; NASDAQ) in paint and plastics, and AMSN in printing and graphic arts. Based on estimates, it is believed that Amazys has overall market share of 17-20%. Color and Appearance customers include Adidas, GE Plastics, GAP, Akzo Nobel, Nestle, Home Depot, etc.


Digital Imaging – 55% of revenue
Customers come from the desktop publishing, printing, packaging and photography industries. An opportunity for growth lies in the fact that color mgmnt is potentially needed by everyone who owns a large format inkjet printer, yet most end users don’t use color mgmnt tools or software (they just eyeball). If Amazys is successful, the potential target market will increase in size by a factor of 2-4x. Wide-fromat-printers.org estimates that eventually another 100,000 owners of wide format printers will have to take the plunge and invest in color mgmnt solutions.

Products range from basic – product gives you a match – to much more complex products – it gives you a match and does formula and job mgmnt as well. Digital Imaging customers include Apple, Creo, Sony, Epson, Fuji, advertising firms, graphic artists.


Industry Summary
The color market spans a variety of areas, from benchtop systems in labs to handheld spectrophotometers used in the field to OEM systems for R&D. In addition, there are devices that measure not just the color, but the hue and the gloss of a coating as well. The biggest trend in color mgmnt, driven in part by Amazys, is making systems software that is easier to use but is still technically sophisticated.

Examples of Color Mgmnt by Fortune 1000 Amazys Customers

GE Plastics – Use Amazys equipment and software to ensure color consistency across batches and product lines.

Nestle – Use equipment and software to measure the color of cookies on the assembly line for the purpose of quality control. If a batch of cookies is the wrong color, it is an indication that the batch was either over or under cooked.

Gap – Use AMSN software and hardware to handle its supplier network. Eg. a factory in Malaysia could be producing a cotton sweatshirt, with a factory in China producing a matching lycra t-shirt. Gap uses AMSN products to transmit the color to the suppliers from HQ, and then the suppliers can confirm with each other that the final product is an identical color.

Home Depot – Installing hardware and software across all stores to allow retail customers to match paint to desired samples.


Strategy
Following a restructuring that took place in 2001, AMSN made a conscious decision to drive costs out of its solutions and to simplify its products. Over the past two years significant steps have been taken to streamline every aspect of operations, whether it be sales and marketing or R&D. Manufacturing has been consolidated and the Company is already seeing significant improvement in operational efficiency.

Software currently accounts for 25-30% of the company’s revenue. Mgmnt is focused on significantly increasing the proportion of software as a percentage of total revenue. Amazys sells software on both a one-time and annual subscription (eg. Recurring revenue) basis. Subscription is $500-$1500 per year and people renew on an annual basis. In other examples, the company licenses a kernel of its formulation software solution - the math engine - in return for a one-time fee. It is the company’s objective to build a recurring revenue stream of high margin software that has a relatively low annual cost to the enduser. Mgmnt believes that it can broaden the market for its products by introducing relatively inexpensive software solutions that have a relatively modest annual subscription fee.

Through a combination of sales growth and operational excellence, mgmnt has publicly stated in presentations that it believes it can grow revenue by 15% a year while increasing EBITA margins from 13.5% in 1H 2003 to 15.0% (Industry margins have historically been as high as 20%).

Analysis of Competitive Environment Using Porters Five Forces - AMSN is a profitable supplier of color mgmnt solutions. Within the industry, Amazys is regarded as the Mercedes of color mgmnt tools. The overall color industry is composed of numerous niches, making it unattractive for larger competitors, but highly profitable for existing industry participants. The strategical analysis below is included to give the reader comfort that Amazys margins and FCF are sustainable.

Industry Rivalry - Competitive industry with three equally balanced competitors operating in a competitive market.

Four competitors > X-Rite (#1), AMSN (#2), Datacolor (#3), Minolta (#4). The primary basis of competition is technology, design, service, and price. The industry has high gross margins (55-60%) which suggests products are priced as innovative solutions as opposed to commodities. All industry participants are profitable and earn their cost of capital, suggesting that the industry deserves to exist.

LTM EBITDA Margins
Amazys – 13.5%, X-Rite – 14.1%, Datacolor – 13.3%

To determine pre-tax returns on capital, we have used (EBITDA-Capex)/Assets. We thought this was the best method for comparison as Datacolor is a division of a larger company, and X-Rite is based in the US (different tax-rate).

LTM (EBITDA-Capex)/Assets
AMSN – 17.5%, Datacolor – 13.0%, X-Rite – 12.0%

We understand that all players have spoken with each other at some point about industry consolidation, but no major deal is imminent. We have spoken with X-Rite and AMSN (but not Datacolor). Mgmnt teams have told us that they view competitors as rational (each of them understand that if they do something stupid on pricing there will be a reaction from the others). Although all industry participants are aggressive on pricing, AMSN mgmnt is confident it can manage COGS and software/hardware mix so that margins won’t deteriorate.

X-Rite is the largest competitor, in part because they offer the most inexpensive solutions. X-Rite is vertically integrated and has to keep volumes high to ensure that margins don’t decline (AMSN outsources most of its manufacturing and is really more of an assembly operation).

In virtually every product review we read, AMSN was chosen as the best value despite what was often a premium price. Additionally, AMSN is a leader in producing software that is compatible with inter-company instruments. The company believes this has produced an innovative advantage, as customers do not want to be bound to a single supplier. This allows AMSN to essentially eliminate switching costs for new customers. In conclusion, AMSN has distinguished itself by offering very high quality and innovation for a reasonable price > Eg. The Mercedes of the industry.


Supplier Power - Components for production are widely available and suppliers do not have excessive power.

Although AMSN has some sole source suppliers, this only occurs when the company does not have sufficient work for more than one supplier. Even in the case of a sole supplier, parts are readily available from multiple sources such that the company could replace the incumbent if price increases are unreasonable. Where volume is sufficient to support multiple suppliers, Amazys has a primary and secondary supplier. Low switching costs provide Amazys with significant flexibility in the event that a supplier tries to put through an unreasonable price increase.


Threat of Substitutes - Although technologies are rapidly changing, the existing industry players are driving the change. Our conclusion, this is an innovative industry, but the key word is evolution, not revolution


Buyer Power - Competitive industry with about average buyer power.

Very little customer concentration, although during some years Heidelberg will account for 5-10% of sales, but that is not the norm. Customers do not typically look for a reason to switch because of familiarity with software/instruments, historical color databases that have been developed over time, long-standing relationships with sales/service people. Overall cost is a relatively small component of total costs for the enduser.

In order to demonstrate the ROI to an enduser, Amazys has quantitative data available to demonstrate that the company’s solutions can save customers time and money. Lastly, this is a high R&D industry (13% of sales for AMSN), with innovation creating opportunities for differentiation.


Threat of New Entrants - Low barriers to entry, but industry is unlikely to attract new competitors of size.

3-4 sizable competitors already dominate the overall industry as well as particular niches, making it difficult for a new competitor to easily grab share. Each of the four major competitors has been in the market for at least thirty years, and some for more than fifty. We believe this is due in part because the industry is relatively small (under US$1b), such that it is unlikely to attract competitors of size. Similarly it takes years to become a color expert, and the proprietary learning curve is rather steep. Likewise relationships take a long time to establish and are a key selling variable.

The other tool we try and use to determine if company has a viable strategy is the Market Leaders Framework:

Customer Intimacy is of the most importance to AMSN, as the goal of the Company is to provide customers with the best total solution. We believe AMSN addresses this goal by offering a broad product portfolio and working with clients to better understand their needs. Despite not always offering the lowest price, AMSN has always managed to win customers by offering a compelling value proposition.

Product Innovation is the second most important variable to the Company’s success. At present, the R&D team is focused on increasing the usability of products without compromising technical sophistication.

We rank Operational Excellence last, despite the fact that there is tremendous upside available from operating improvements. The Company recently tweaked its SAP system (note we say tweak, not reinstall or implement) to provide better information on cost mgmnt. We have spoken with the CFO, and improvements are already being realized.


Operating Improvement Potential and Sales Growth
Mgmnt believes AMSN can grow sales at 15% a year and improve EBITA margins from 11.2% to 15% by 2005. 1H ’03 sales growth in constant currencies was ~17% (actual reported growth of 7.8% due to strength of Swiss Franc). Mgmnt truly believes this will be a $200m to $400mrevenue business within 3 to 5 years ($126m on an LTM basis). According to an April 2003 Analyst presentation, market growth will be achieved as follows:

Defend and Extend: Paint, Auto, Plastic, Textile, Prepress, Pressrooom, Ink, Photo Processing.

Penetrate and Grow: Digital Photo Processing, Digital Photography, Creative, Digital Printing

New Emerging: Digital Supply Chain, Digital Color Appliances, Digital
Projectors, Digital Cinema

The 15% growth figure includes about 10-12% organic growth and 3-5% from small tuck-in acquisitions.

The Company has already seen very positive signs over the last year including deals with Sony, Epson, Wal-Mart, Home Depot. A fair amount of growth for the digital imaging division is in the bag for 2004/2005 due to 2004 DRUPA. Drupa is an international printing tradeshow held every four years, and historically acts as a strong stimulant for sales both during and one year after the show is held. Heidelberg typically releases new products at each Drupa, many of which incorporate various Amazys products or software.

The company is currently working on several new technology platforms that will deliver improved capability in performance, convenience, and ease at price points that the industry does not currently offer. As such, AMSN expects to create an opportunity to apply the company’s specialized color know-how to a variety of technologies that will broaden the market and increase the size of the color industry from US$1 billion to almost US$2 billion. Overall growth should also come from exposure to hot markets, whether it be sectors like digital cameras, or geographies like China.

The readers should note that given the depressed valuation, this investment is not dependent on rapid sales growth to deliver excess returns. Additionally, new initiatives are covered by the current R&D spend/capex, so there is really no downside if the company is not successful in reaching its 15% sales per year target. In effect, an investor is getting a free call option on potentially super-charged growth that could turn this investment from a double into a home-run.

On the margins side, we are very pleased with progress to date. EBITA margins in 1H 2003 were 13.6% compared to 11.2% in 2002. The Company currently has very high operating leverage based on the fact that the Board has brought in an expensive mgmnt team that is capable of taking the company to CHF400m in sales. In addition to a top quality CEO, the Board brought in a CFO who previously acted as Financial Director for a large division of Siemens. We have met with the CFO and were very impressed by his thorough understanding of operations as well as corporate finance/financial engineering.

With respect to compensation, we are big believers in the phrase “You get what you measure”. When the new CEO came in he aggressively redesigned compensation for the top 20% of employees to emphasize variable performance (both quantitative and qualitative). As such employees must now hit specific quantitative metrics if they want to earn their bonus. Similarly, compensation for the sales team has been reworked based on an increasing commission scale such that winners win big and losers are likely to leave the company.

Basically this is already a very cash generative business at the current run rate, but the Company will literally be printing money if margins/revenue growth comes even close to hitting mgmnt’s targets.


Working Capital
Mgmnt is operationally focused and has already freed up CHF8m from working capital over the last two years. NWC as a percentage of sales has declined from 22.8% in 2001 to 19.1% in 2002. We expect continued declines going forward, although future improvement will be much more moderate. Both the CEO and CFO believe there is still room to improve DSO and inventory turns which should bring NWC as a percentage of sales down to around 18%. The mgmnt team could get it lower by extending payables, but this does not make economic sense since you get a higher ROI on an annualized discount by paying quickly and taking the net discount.

Capital Allocation
We are not worried about mgmnt completing value destroying acquisitions. The CEO and CFO are both conservative and focused on margins, ROIC, working capital, etc. CEO has told us that acquisitions have and will take place at roughly 5x EBITA (excluding any synergies) and will be small tuck-ins. We understand that recent acquisitions seem to be progressing well and provide access to new markets and customers that the Company did not previously have exposure to ($4.5m spent in 1H ’03, nothing in ’02). Mgmnt is very focused on ROIC and cash on cash returns, and does not strike us as empire builders that will erode value.

Management
CEO – Tom Vacchiano (also a member of the Board)
Veteran technology exec with experience at NCR, Xerox and Digital Equipment Corp. Most recently Tom was head of Xerox Engineering Systems (XES). XES was a $400m subsidiary losing $36m pre-tax when Tom was recruited to lead the division. The first year he managed to trim the loss to $6m, and by the second year it made a pre-tax profit of $18m. After 2.5 year Xerox bought Tom out of his contract for a considerable sum. In our view, he is honest, non-promotional, intelligent, detail-oriented, strategic thinker, people person, finance background, productivity zealot – He is the “real deal”.

Readers should note that despite being a Swiss listed company, Amazys is for all intents and purposes a US company with a US CEO, US headquarters, US R&D shop, etc.


Relative Valuation
We never really look at relative valuations, but in case you disagree here are the comparable LTM numbers for the two pureplay industry competitors, X-Rite and AMSN. Both companies are in the same industry, have similar customers, similar capital structures (actually Amazys has a stronger balance sheet and a lower tax rate).

AMSN
EV/EBITDA – 5.1x
EV/EBITA – 5.9x
EV/(EBIDTA-Capex) – 6.1x
EV/FCF – 8.0x

X-Rite
EV/EBITDA – 14.7x
EV/EBITA – 23.5x
EV/(EBITDA-Capex) – 16.6x
EV/FCF – 22.7x


Currency Exposure
Company is operationally hedged, so only exposure is translational. As USD investors we are indifferent, as a rising Franc should mean we benefit from currency appreciation even if the stock price declines commensurately. Regardless, Franc is virtually costless to hedge if that is your preference.


Too Small For Me to Waste My Time Argument
Avg daily volume according to Bloomberg was ~5,000 shares during the past 3 months. Looks like large blocks trade every now and then (at least Bloomberg says they do).


Catalyst
We have spoken with members of the Swiss investment community, and we believe the stock will be viewed in a more positive light once the two remaining founding shareholders step down from the board within the next 18 months (due to age restrictions).

Even if growth does not materialize (which we think it will), the stock will continue to attract value investors given 12.5% FCF yield. Cash is king, and investors have begun to realize that this company prints. Lastly, there is the potential sale of the tech park that would generate cash equivalent to ~9% of the enterprise value assuming the site is sold at a slight discount to its listed price.

Catalyst

We have spoken with members of the Swiss investment community, and we believe the stock will be viewed in a more positive light once the two remaining founding shareholders step down from the board within the next 18 months (due to age restrictions).

Even if growth does not materialize (which we think it will), the stock will continue to attract value investors given 12.5% FCF yield. Cash is king, and investors have begun to realize that this company prints. Lastly, there is the potential sale of the technology park that would generate cash equivalent to about 9% of the enterprise value assuming the site is sold for a slight discount to its listed price.