Description

Cenveo

Cenveo (“CVO”) common stock is both a leveraged equity and an event driven stock where the positive event has happened and the stock is still on its lows in part due to 1) its sub $1 price, 2) lack of material sell side coverage, 3) high leverage, 4) misunderstood business model and 5) the recent sell off from Brexit. Ironically, the debt has all rallied materially off the lows (the 2^nd Lien paper alone has doubled over the last two months). In short, the debt market has gone from predicting bankruptcy to just plain financial distress, while the equity market is still pricing the common stock as a way out of the money call option. The Company should have pro forma cash earnings power of between $0.65 and $1.00 per share and the stock should be re-rated to the $3 – 6 range. The debt is also still a buy in spite of the recent rally, but the common stock is the best risk-reward in the capital structure right now.

Background

CVO is run and effectively controlled by the Burton family who collectively control about 13% of the stock. The Chairman, Rob Burton Sr., led the successful LBO of World Color Press for KKR and took over CVO about 10 years ago in an activist campaign. His son, Robert Burton Jr., is the CEO. Their tenure at the helm has been controversial in part due to high compensation, but more from what to-date has been an unsuccessful LBO for shareholders who thought that World Color success would be repeated.

The activist campaign was successful, but the Company’ stock has not been a winning investment due in part to high multiples paid for assets, secular decline in the commercial printing sector (which is now a de minimis part of EBITDA), the financial crisis and trouble integrating the recently acquired National Envelope business out of bankruptcy. The Company recently sold its packaging business for about $100mm of net proceeds to help finance the cash portion of a debt exchange offer that should give the Company enough room to execute against its business plan.

To be fair to the Burtons, whatever the missteps of the past, they negotiated a debt exchange when the 2nd Lien and unsecured debt was trading in the 30s to 40s without material dilution to the common stock Issuing 19.9% of the stock in new warrants while effectively eliminating the dilution that was part of an existing convertible bond (though it was way out of the money with a $4.14 strike), which is what they said they would do. If actions speak louder than words, the Burtons have been acting in shareholders’ best interests despite enormous pressure from debtholders and advisers to flush the common stock in a prepackaged bankruptcy.

The Business

CVO is really three different businesses. The first of which is a commercial printing business that is the smallest in an industry that is experiencing secular decline. This segment was hit hard in the crisis just as the secular headwinds accelerated. The Company has never really recovered from the leverage, EBITDA contraction and multiple contraction that hit this segment. The business is now only 12.5% of operating income. Unfortunately, this line of business is what many if not most market participants think the business is all about: contracting the multiple people are willing to pay for the enterprise. The business now appears to have stabilized, generates modest free cash flow and helps absorb corporate overhead. It is doubtful that it could be monetized at an equity accretive multiple, given that comparable companies trade at 4-5x EBITDA on a good day. It is the low multiples of this segment and sector that drag down the valuation of the entire enterprise.

The second line of business is the label business, which generates 32.5% of operating income. This business is divided into two segments. The first is a large scale commercial prescription label business for drug stores. It is a low margin high volume business with only two other competitors and obvious customer concentration. That said there are decent scale barriers to entry as well as compliance barriers as the labels must be accurate (think getting dosage correct and what can go wrong if it’s not readable or accurate on the packaging. The other is a small run printing business for things like concerts or cd packaging and other small runs. This business is high margin, but small scale. Sales are generated over the internet.

The third and final segment is the commercial envelope business, which is 55% of operating income. The Company dominates this segment with approximately 60% and growing market share. The business is driven by junk mail, primarily through credit card solicitations. The segment generates roughly 10% EBITDA margins. There is some cyclical growth from the coming election cycle as campaigns still do mass and targeted mailings. There is also an uptick in business from American Express that is mailing to regain customers lost due to Costco’s decision to drop them. This segment is where most of the future EBITDA growth can come from three separate areas. The first is from technology investment that can take labor costs out of the process via automation, the second is from acquiring a few remaining mom and pop operators out which should be able to generate about $10-20mm of EBITDA for about 3-4x. Finally, management believes that they can get margins over time to the mid to high teens as market share approaches 70%. They sold the same business in Canada with that type of share and it was able to improve pricing and margins to get approximately 16-17% EBITDA margins. They believe that at least 200-400bp should be achievable over time.

Financials and Valuation

The Company is forecasting $155 – 160mm in EBITDA for 2016 with about $25mm of CapX and $71mm of interest expense. CVO will generate about $61mm or $0.75 of free cash flow a share. As a simplifying assumption, we have assumed that all the warrants will be exercised and that roughly $20mm of cash will come into the Company though that will obviously not be the case in scenarios where the equity trades for less than $1.50. The Company’s income is largely shielded from taxation from NOLs that we shall value by not taxing the next three to four years of cash flow generation.  Management clearly believes the high end of the range is feasible, but we are modeling the mid-point. We grow revenues by 1% and have margins creep up to 11% by 2020, where EBITDA is close to $200mm. We keep CapX at $25mm which is elevated for acquisitions and technology investments.

What is interesting is that CVO stock is clearly very valuable on a free cash flow per share basis. Even if you tax effect the $0.75 in 2016 cash EPS to $0.45 and put 5-10x that number, you have a $2.25-4.5 stock today, and you should add about a dollar for the present value of NOLs. The issue with valuation is that it is hard to put much more than 6x EBITDA on the business even though, the company generates far more free cash flow than that multiple would warrant. It takes 7x 2016 EBITDA to create only $1.20 in equity value. However, the equity becomes substantially more valuable as the Company pays down debt in the coming years. 6x EBITDA when combined with debt pay down, creates a value per share of $1.69 to $7.72 in the years from 2017-2020. A mere 5x cash EPS creates a range of $5.24-7.92 in the same time period.

So, what is the market missing and what are we missing? This Company is not fully out of the woods. While they can fund the 2017 maturities though ABL availabilities and cash generation, the 2019 first lien debt is both very inexpensive at 6% and trading at a 13% yield which would be hard to roll if CVO doesn’t hit their numbers. That said by year end 2020, net debt/EBITDA should be under 3x, the debt markets should be able to refinance that at a reasonable rate in 2019. There is also a requirement that approximately $88mm for the packaging sale be reinvested in the business under the first lien indenture. The $25mm of CapX clearly qualifies. The Company appears to be making the argument that some amount of debt pay down should qualify as well as acquisitions. CVO has 12 months to figure this out, but it may also be required to pay back some portion of first lien debt under certain scenarios. However $105 of ABL availability plus free cash flow generation should be able to handle this issue.

No one really covers this credit; the few sell siders I talk to don’t even have a pro forma cap. table created for the exchange offer.  However, insiders get it and are buying large amounts of stock right here and now. I have been buying and so should other VIC members.

Risks

Further secular decline in printing. A recession that cuts back on direct mail advertising.

Catalyst

Massive deleveraging and refinancing as well as accretive acquisitons.