Description

CafePress represents a unique opportunity to participate in a revenue growth story with sector tailwinds and embedded margin and multiple expansion potential, at an inexpensive valuation.

In summary, on topline PRSS benefits from double-digit growth in retail-wide e-commerce sales, plus additional growth from the trend toward personalization. On margins PRSS should benefit from a consolidation of six manufacturing locations to a single optimally-located, lower cost facility in Kentucky that will be completed later this year. And on valuation multiples, PRSS has been in the penalty box for significant misses on guidance in its first couple quarters after its IPO last year. These multiples should rebound once the company puts together a string of solid quarters and proves it can deliver on the growth and margin story it has pitched since the IPO. If the company executes on its sizable opportunity, we believe the stock price could more than double in the next 18 months.

About the company:

PRSS is a Sequoia-backed company (they are still the largest shareholder at 17%) that provides customized consumer products, most commonly thought of as t-shirts, mugs, buttons, etc., but actually spanning over 600 kinds of base goods. While they started out as a user-generated, “create and buy” site, they have evolved into a platform that allows individual designers, small shops, and large corporate brands to offer their own custom products, resulting in a marketplace of over 2 million shops, and millions of crowd-sourced designs for consumers and organizations to “find and buy” as well as create and buy. CafePress’ goal is to be the customization engine for e-commerce wherever it occurs, and describe their core competency as building high-quality, customized product efficiently, in very small order sizes (average order size is ~$50).

Why is it down so much?

PRSS’ stock price is down 65% since it IPOed at the end of March, 2012, and its next-year forward multiples have dropped dramatically as well (see table below). The main reason for the significant price decline and multiple compression is the fact that the company, in its first and second quarters immediately following the IPO, slashed forward guidance (8% on revenues, and 39% on ebitda). The reason they cut their guidance was primarily because of search algorithm changes at Google, which hurt revenue at small shops which depend on keyword traffic, but also from declines in political and international revenues. While the change in search algorithms was not something they could have predicted, the other two declines, especially coming in guidance less than 3 months after their IPO, seems like something they should have seen coming. This failure so near to their IPO did major damage to management credibility. While the last two quarters’ (Q4 2012 and Q1 2013) results have been more positive, with the company surpassing the high end of guidance, they have not yet regained investor confidence, especially because they continue to be in a manufacturing consolidation and acquisition integration process, and don’t expect normal margins to resume until the end of this year. The street appears to be waiting to see whether the company can actually deliver consistently on their targets. Below is a table comparing the company’s post IPO multiple with current levels, and with e-commerce industry multiples. For the industry multiple I used a comp set that has essentially the same revenue growth rate of 24%. (For the full comp table see farther below).

While future search algorithm changes will continue to be a risk to the company, exposure has declined over the past year, as the percentage of revenue from the small shops that are most affected by algorithm changes has significantly decreased. The overall shops segment makes up less than 15% of total revenues, and the small shops portion has been getting smaller, while the corporate branded shops portion has been growing at 50+%.

Sector tailwinds:

National e-commerce sales have been growing at around 15% a year, much higher than the overall retail growth rate of around 5%. Projections for the next 5 year CAGR for e-commerce range from 10 to 15%*. Meanwhile, the primary product category that PRSS sells into (apparel and accessories) has the highest sub-category growth projections at ~17%. According to second-hand conversations with the current board member from Sequoia, Sequoia’s thesis when they invested in 2005 was that CafePress was a macro play on the growth in e-commerce, and that layering personalization on top of e-commerce results in an even more attractive growth-rate opportunity. That opportunity still appears valid, and is supported by the company’s long-term growth rate target of 20%.

*a comparison of 6 different projections, as well as sub-category projections can be found at http://www.emarketer.com/Article/Retail-Ecommerce-Set-Keep-Strong-Pace-Through-2017/1009836

Competitive advantage?:

Determining if the company can have a competitive advantage is important in a category which has no real technical barrier to entry in the actual production of customized t-shirts, coffee mugs, buttons, canvas paintings, etc. The company believes their evolution into a platform that focuses on quality and efficiency is their source of competitive advantage, for several reasons. As a platform they benefit from having a very large community of sellers and a long-tail of unique find-and-buy products. This broad reach creates network effects and a pool of demand for both CafePress and independent sellers on their platform, and an important advantage to scale for the company. For example, CafePress has over 500k followers on Facebook, and over 8,000 people currently talking about CafePress, versus their nearest-sized competitor, Zazzle, which has 79k followers, and some 600 people talking about it. Unlike for some vendors, this social presence actually drives real revenue for CafePress (revenues from social media channels were up 122% yoy in the most recent quarter). Clearly there is a virtuous circle here where the more people talk about, buy, and sell on CafePress, the more others will as well, so it’s up to the company to leverage the lead they currently have as the #1 consumer product customization company.

Additionally, CafePress has benefited from a focus on quality, which differentiates them from many other customized product vendors, which sell products that are often used just once and tossed aside (for example, a corporate event t-shirt). The CEO and CFO told us they believe their focus on building high-quality product has enabled them to win major corporate partners (such as ESPN, ABC, Paramount, Marvel, and Michael’s), which have their own shops on the platform, and represent one of the fastest growing segments of the business.

Finally, while it’s not hard from a technical perspective to build customized consumer products, building millions of them, most of them as a unit order of one, at low cost, is difficult, and while we don’t know the financials of their smaller private competitors, can reasonably conclude that CafePress’ size and soon-to-be centralized manufacturing location in Kentucky (where they have low cost of labor, tax incentives, and are co-located with UPS) provides them an opportunity for better margins than smaller competitors. Their largest competitor Zazzle builds some products in San Jose and outsources others. CafePress believes that of the products built in San Jose they clearly have a production cost advantage with their operations in Kentucky, and have higher quality than the outsourced products.

Margin and multiple expansion potential:

The company is currently consolidating six scattered manufacturing locations into one facility in Kentucky, and is investing about $6 mm of ebitda to complete this during the fourth quarter of this year. They expect a margin rebound after Q4 when this is complete, due to lower shipping and labor costs. Pre-IPO they said their long-term targets were 20% annual growth rates and mid-to-high teens ebitda margins. Despite the disappointments of last year, they still stand by these targets, and on the Q4 earnings call, they said they believe they can return to double-digit margins next year, as a result of the manufacturing consolidation. We asked the CEO and CFO why they haven’t reached their long-term margin targets in recent years (they claim they did in 2009, presumably on an adjusted basis), and they said that they have been investing for growth for the last several years. We think they will continue to have to invest in growth and will likely face pricing pressure, so we take the mid-to-high teens margin target with a grain of salt, but there is clear room for expansion from current levels of around 5% (on guidance this year, excluding the $6 mm consolidation expense, they would reach 7.7% ebitda margin), back toward historic, unadjusted levels near 10%.

As discussed above, because of the major guidance revisions immediately post IPO, trading multiples have significantly compressed. Should the company put together another couple quarters of meeting guidance, as they have begun to do with the last two, we believe investors will accord them a higher multiple. Based on e-commerce comparables and the company’s own multiples before it began slashing guidance, there is considerable room for expansion for a company growing at their rate. See the table below for a set of e-commerce comparables:

Target price:

For our target price we assume the company reaches guidance on revenues of $255 mm this year, and grows in the low teens in 2014 resulting in ~$288 mm of revenues. On margins we assume that they get back the $6 mm (2.4% of revenues) they are spending on consolidation this year, and benefit by another couple million from higher efficiencies next year, resulting in $24 mm of ebitda or an 8.4% ebitda margin, significantly more conservative than their projection of double-digit margins next year. Applying a 10x 2014 ebitda multiple (comps are 14.5x), and assuming only moderate cash generation of $10 mm, results in a target price of $16.05, and upside of 140%. The fact that our revenue growth and margin assumptions are more conservative than management’s, and our target multiple is well below industry comps shows how much this name has been punished, and how little trust is currently being placed in the company—and how much upside there may be should they execute.

Risks

Management execution. While the CEO and CFO talk as though they have learned lessons from the guidance disappointments of last year, and their business is diversified away from and has less exposure to the same issues, management still comes across as promotional on calls, leaving us with less confidence.

Competition. Even though Zazzle appears to be smaller and generating less online buzz, and likely has higher costs of production, their online merchandising appears very good—see their website. If they out-execute, they could cut CafePress’ growth. Additionally, high-end custom product marketplaces like Etsy could move downstream and cut into wallet/mind-share for CafePress. Or Amazon could decide to enter this space. Clearly Amazon’s distribution network and technology expertise would make it a strong competitor, though it does seem that certain processes and know-how that CafePress has developed over the years in building small orders efficiently would take cost and effort to replicate. Additionally, Amazon is a big sales partner of CafePress, listing and selling a lot of CafePress merchandise. At these prices, it probably would make more sense to acquire CafePress than to build it.

Cost of customer acquisition. Due to a variety of issues, such as further search algorithm changes, market saturation, etc., customer acquisition costs may go up significantly, preventing CafePress from reaching its promised margins.

Market trends/popularity for customization. Growth could be limited by changes in the popularity of customization or the manner in which it is delivered (like 3-D printers).

Major disposition by VC’s. According to second-hand conversations with Sequoia’s board member, a sale for them at these price levels seems unlikely, but could become more likely if the stock returns to double-digit levels.

Catalyst