Description

A purchase of BNE common stock offers you a stake in the world’s dominant financial documentation service provider at a conservatively estimated 10% mid-cycle after-tax free cash flow yield, with considerable upside from there. BNE is a staid and stable earner, generating high returns on capital throughout the capital markets cycle (10% pre-tax at the cyclical trough, 20-25% at mid-cycle) as a result of customer captivity. With only two competitors of any size (RR Donnelley at 30% share and privately-held Merrill with 20% share), BNE boasts a leading market share of roughly 40%. Having executed significant changes in its cost structure over the past three years, BNE is poised to produce meaningfully higher profit margins than during previous cycles as capacity-driven operating leverage shines through with an up-tick in capital markets activity. This leverage should be evident in the latter half of 2005 and will build with a sustained increase in M&A and IPO transactions. Although BNE does not represent the most exciting of opportunities, its low downside risk coupled with its predictable (if lumpy) cash flows and leading market position, as well as positive catalysts in a rebounding capital market environment make BNE an attractive investment on a risk-reward basis. The margin of safety lies in both the valuation and the strength of the underlying business (proven over the unusually harsh four-year trough of 2001-2004). BNE has paid uninterrupted quarterly dividends since its IPO in 1968.

Founded in 1775 (that’s not a typo), BNE provides printing, communication and other document services for the transactional, compliance, and corporate and mutual fund reporting requirements of its mostly financial services industry customers. BNE also manages a globalization segment called Bowne Global Solutions (BGS) that provides interpretation, translation and localization services to adapt products and communications for use in foreign countries.

Financial print has two parts: the predictable and recurring non-transactional business (mostly compliance work like 10Ks, 10Qs, 8Ks, annual reports, etc.) and the mature, highly cyclical and very profitable transactional business (mostly M&A and IPO transactions). The non-transactional business, while not excessively profitable, provides a core stream of business to utilize type-setting capacity. Two trends are currently affecting the compliance business: (1) the SEC is mandating more filings with quicker turnarounds and (2) mutual funds are consolidating. The former should drive compliance printing revenues with the increased emphasis on more and better disclosure (8Ks in particular), while the latter should hurt the mutual fund annual report business as the customer base contracts.

On the transactional side, BNE generates its competitive edge through a combination of sticky customer relationships and generally price-insensitive end-user clients. The sales relationships, forged between the BNE sales team and, for the most part, lawyers and bankers, results in repeat business as customers generally do not switch providers. Further, because (1) the attorneys and the bankers typically handle the documentation on behalf of their corporate clients and rarely shop around, and (2) the cost of documentation is dwarfed by the overall transaction costs, customers are somewhat insensitive to pricing (see NOTE at end of write-up). All this adds up to high, protected returns, and 230 years of building customer relationships has put BNE in the enviable position of market leader of this profitable industry. Although those assets can presumably walk out the door, they can only walk to two other shops (since building the necessary infrastructure is prohibitive and the expected returns not juicy enough for a fledgling effort). History has shown that in practice, on net, relationships are stable.

Although the company is thought of as a “printer,” it actually makes its money on the typesetting (the initial creation of a document). Having typesetting as the core competency is critical because it protects BNE from (and may help them exploit) the shift to digital technologies from physical document delivery – think email versus snail-mail. The same typesetting work is required no matter how the document is distributed, or even whether it is physically distributed at all. Because typesetters are highly skilled laborers, BNE must keep them on payroll throughout the cycle, making capacity utilization a critical element to profitability. Although non-transactional business keeps typesetters somewhat busy, the transactional side really provides the operating leverage bang. The past four years have been a real drought, with average annual transactional revenue coming in at around $265 million versus over $425 million in 1999 and 2000 and an estimated mid-cycle level of around $325-$340 million. Even so, BNE maintained financial print segment EBIT margins of around 4% through the trough (compared to 10-16% in peak years). The average since 1998 (when the financial print segment was first broken out separately) is about 8%, though the business as a whole has run at average EBIT margins of 10% since 1989, including the drag of BGS.

With increasing transactional business, however, these margins are likely to improve over historical levels due to operational changes made over the past few years. The benefits from these changes have not been evident yet because volumes have not been sufficient to demonstrate them. There are two broad areas of change: consolidation and closure of facilities (both typesetting and printing), and the shifting of typesetting labor to India. Over the past eight years, BNE has gone from 15 decentralized typesetting locations and 1,050 typesetters to six centrally-controlled locations and 650 typesetters. Central control allows BNE to easily spread jobs across all of its facilities so as to best utilize its assets. The bulk of the reduction of typesetters has been offset by a shift to India via an exclusive third party provider, where BNE realizes cost savings of about 30-40%. Currently about 15% of its typesetting business is handled in India (all non-transactional), and the company hopes to move an additional 15-25% over as India becomes better able to handle more complex jobs. Also, since 1997, BNE has reduced its manufacturing (printing) facilities from 15 to seven, as it continues to outsource more of its printing needs from domestic printers. The net result is elimination of low profit, asset-intensive business, and a presumably concurrent improvement in ROC. As a result, depreciation is expected to decline from $40 million in 2003 to roughly $25 million, more closely approximating maintenance capex levels. A new typesetting technology platform currently being implemented, called ACE, should also lower costs, although the exact impact is difficult to quantify. In any case, as business picks up the restructuring should bring financial print segment EBITDA margins to 15-18%, from 10% LTM levels.

Although I don’t put much stock in quarterly results, particularly for a company with lumpy earnings like BNE, I will make quick mention of some possible quarterly eventualities. Although M&A (and to a lesser extent, IPO) activity has clearly picked up of late, the impact of recently announced transactions likely won’t be felt until Q205 as a result of revenue recognition policies (when BNE’s services to its customers are substantially complete). Q105 should still prove to be a successful quarter as the seasonal nature of compliance reporting (skewed towards calendar year-end 10K issuances) drives high utilizations. I do not have any particular view on Q404 (which will be announced on 2/16), but do not expect any meaningful pickup (or decline) in financial print performance. The major risk in the upcoming release is on possible pricing pressures on IPO transactions (as competitors, particularly Merrill, cut prices to drive utilization after a dismal trough) or uneven performance in the BGS segment, which I discuss below. This was a $12 stock after the last bad release in October, and after tomorrow’s release we may again see $12 (or we may not). Be aware of this short-term volatility risk.

In Q404, BNE sold its non-core and relatively unattractive outsourcing business segment for a rich multiple, resulting in $150 million in after-tax proceeds. $70 million of these proceeds were used to pay down high-cost debt (including a $10 million make-whole provision), $40 million to begin a repurchase program and the remainder kept in reserve for future repurchases. Until the ongoing repurchase program is finished, approximately 10% of the daily volume is repurchased by rote by Bank of America. So far about 750k out of 2.5 million shares (the total representing 7% of shares outstanding) have been bought in, providing protective buying support for at least another quarter or two. Future repurchases will also act as a buffer.

Following the sale of the outsourcing segment and in addition to its core financial print business, BNE is left with BGS and a small, profitable litigation consulting business carved out of the outsourcing sale. BGS provides globalization, interpretation, translation, localization and technical writing services to adapt products and communications for use in foreign countries. “Localization” is the adaptation of content and products to meet language and cultural requirements; “technical writing” is the creation of technical documentation; and “interpretation” is the providing of interpreters to government agencies and commercial organizations for international meetings and events. BGS maintains a network of employees and independent translators, authors and interpreters around the globe.

Traditionally, globalization services have been managed in-house using a large cottage industry of small translation and localization contractors located in different countries around the world. The industry is now consolidating, with 3 major players (BGS, Lionbridge and SDL International); BGS is the market leader. Industry growth has been fueled by the secular outsourcing trend of non-core corporate services, as well as the continued globalization of existing and would-be multinationals. As companies “go global,” introducing their services and products requires preparation of manuals, documentation and content in multiple languages (see today’s Microsoft/BNE press release as an example). Historically the business has been skewed towards technology companies, though BGS is trying to diversify its customer base as it has been plagued by software release and other IT product delays.

Although it is profitable, BGS has yet to show its potential as a viable business and has not earned its cost of capital for BNE. It is difficult to motivate customers to switch from entrenched in-house capability. Management readily admits the value proposition isn’t even really there for many very large or very small companies. Further, with capacity utilization again playing a key role, the choppy and unpredictable nature of the business makes it difficult to leverage the huge fixed infrastructure costs. Although BGS is the market leader, its 4% share does not afford any real scale benefits.

Management rightly is not committed to investing in BGS, and views it as largely a management headache in a non-core business (and one boasting no synergies with financial print). Although BGS has a future, and potentially a very fruitful one, it is best realized by others more amenable to the task (maybe a large consultancy?) or as a separate entity like publicly traded Lionbridge. In 1999, management hired Goldman Sachs to review “strategic alternatives” for BGS, but decided not to go ahead with a sale at that time. A sale or spin-off of BGS should unlock shareholder value, leaving BNE as a pure-play financial typesetter/printer.

Some quick figures ($ and shares in millions):

Calculation of Enterprise Value
Shares out following repurchase program: 34
Market value of equity at $15/share: $516
Net debt following repurchase program
and debt paydown $19
Enterprise value $534

Calculation of Mid-Cycle Earnings (before impact of operational restructuring)
Non-transactional print revenue $375
Transactional print revenue $335
Total financial print revenue $710
Financial print EBITDA margin 13%
Financial print EBITDA $92
BGS revenue $225
BGS EBITDA margin 5%
BGS EBITDA $11
Litigation support revenue $40
Litigation support EBITDA margin 13%
Litigation support EBITDA $5
Total EBITDA $109
Depreciation = capex $25
EBIT ~= EBT $84
Taxes at 40% $34
FCF $50

FCF yield 10%

At $15 per share, BNE is likely fairly valued based on historical mid-cycle earnings and a no-growth scenario for its globalization and litigation support segments. This is a reasonable price to pay for a 230-year old market-leading financial print business supported by relatively strong barriers to entry (based on customer stickiness) and two somewhat unremarkable but still valuable entities in BGS and litigation support. With the recent sale of the outsourcing segment and the resulting debt reduction and share repurchases, management has shown themselves to be actively aligned with shareholder value. A not unlikely sale of BGS will also increase value by eliminating a confusing and relatively unattractive business from the mix and providing a bigger stash for repurchases or special dividends. The recent operational restructuring and technology enhancements have resulted in a much more leverage-able cost structure that should lead to significantly increased profitability as capital markets return to normal levels (at peak levels BNE should be a cash machine). Finally, there doesn’t seem to be much downside from here. At a 6% after-tax LTM free cash flow yield based on pretty awful recent performance and a 10% mid-cycle yield (before the consideration of expected margin improvement from the aforementioned factors), supported by a resilient and protected core business, we have a meaningful margin of safety. Protracted poor share performance, tired investors, a seemingly endless cyclical trough and a multi-year restructuring period all conspire to provide a good entry point.

NOTE: As an aside, where BNE really makes its money is on mid-job changes. You can think of BNE like a residential building contractor. When you lay out the plans for your new kitchen, the contractor sets a price whereby he makes a reasonable though not very good profit. If you stick to that plan, he leaves with some pocket change and you get your kitchen as planned. BUT, as soon as you decide to alter those plans (add an island, put that glass in the cabinets, go for the fancier tiles), the price (and his profit) move up disproportionately. Even worse, you decide you need the kitchen done by March instead of April. You may get what you want and be happy, but I guarantee you’ll have an even happier contractor. For BNE, the same holds true – more changes (thank you, attorneys) means more profits. In addition, large jobs tend to be more profitable than smaller ones because large jobs typically require more mid-job changes and pricing plays a distant second fiddle to timely execution.

This is my first submission to VIC. Your questions and comments are greatly appreciated. Both my employer and I personally hold shares in BNE.

Catalyst

- Improved capital markets activity and resulting operating leverage
- Possible sale or spin-off of BGS segment
- Continued share repurchases