Description

Cadmus is a printer with stable/growing EBITDA and low capital spending requirements. This results in significant free cash flow for debt reduction, which should accrete to market capitalization (approximately 12-15%/year) if the company's conservative enterprise multiple remains unchanged. We think the business is worth approximately $350mm ($20/share) to a private equity sponsor, and likely more to a strategic buyer.

We rarely find opportunities with such good downside protection and potential for mid-teen returns by management doing nothing more than maintaining flat operating performance and using the FCF from the business to pay down debt. Obviously, any multiple expansion or EBITDA growth (which we do actually expect) provides much more upside. Management has demonstrated discipline with FCF in the past through massive debt reduction, rather that spending it on spurious acquisitions. This is the cap structure as of December (2Q05):

2Q05 (all $ in mm)
Market Cap 123.6
Revolver ($100mm) 36.5
8.375% Sr. Sub '09 125.0
Cash 0.0
Enterprise Value 285.1
LTM EBITDA 55.0

In the past few years, typical printing companies have proven to be a difficult investment. New printing technologies are extremely capital intensive but have increased printing speed and reduced delivery times. This has accentuated the gap between small and large printers, and in an attempt to gain scale through acquisitions, balance sheets have become over levered. The commodity nature of the business makes pricing power extremely difficult, especially when exposed to volatile end-demand such as ad pages and subscription sales. You are left with a business that is fighting declining margins, financial flexibility and ROA.


Why is Cadmus any different?


Cadmus is the leading provider of outsourced publisher services to scientific, technical, and medical (STM) journal publications and the nation's 5th largest periodical printer. The Publisher Services segment generates 90% of the firm’s total operating income and corners 40% of the STM market (3x the nearest competitor). Historically the company has earned a premium for its integrated end-to-end services from content management to printing and distribution. The second segment of the business is Specialty Packaging, which offers proprietary packaging to the healthcare and apparel markets.

Over the last five years the new CEO has slowly transitioned the business from a manufacturing/vendor of traditional print to a service/resource provider of content management. This has proven to be a very successful move. Operating margins have steadily increased over the last three years, a time when every large printer has seen significant margin erosion. Over the last four years the company has paid down over $65mm in debt- current Debt/EBITDA is the lowest in 5 years and among its peers, just under 3.0x. In addition, management plans to use future free cash flow to de-lever the balance sheet (est. ~$15mm for this year) and in turn grow the shareholder’s stake in the enterprise. Although new growth is not required to make this an attractive investment due to the steady cash the business generates, current initiatives that leverage the proven business model into other “essential information” markets are free call options for investors since the infrastructure is already built. Our estimates currently do not include any volume increases from the company’s move into this market.

One of the biggest problems with CDMS is its limited float (on average only $1mm of volume trades weekly) and waiting for a financial buyer to come along could lead to old age. In the event that a buyer does not appear, the reduction in debt over time should result in lower interest expense and increased FCF which could be returned to shareholders in the form of increased dividends or stock repurchases, all of which provide additional upside potential.


VALUATION
CDMS equity is currently trading at a deep discount to fair value- trailing twelve-month FCF yield is 15% (EBITDA-capex-interest-WC-tax) with a modest P/E ratio of 8.8x. For FY05, we are currently modeling $54mm of EBITDA and EPS of $1.60, slightly conservative to the company’s projections. Management’s current outlook for FY05 is flattish sales growth, $56-58 of EBITDA, EPS of $1.62-$1.67, capex of $14-16mm and debt reduction of $14-17mm.

The total enterprise value is currently trading at 5.2x EBITDA and 6.7x operating cash flow (EBITDA-capex). The most recent and comparable M&A transaction in the space was the purchase of Sheridan in 2003 by Jeffries Capital and BRS from BankBoston for $147mm, or 5.8x LTM EBITDA. Cadmus paid $198.7mm for Mack Printing in 1999 (the #2 player at the time), or 6.9x after synergies. Public comps trade for upward of 6.0x (CVO 6.6x, RRD 7.0x, IQW 6.5x, BN 6.0x). If CDMS’s EV multiple were to trade in the middle of this range, this would represent a current 50% appreciation from current levels.

The company’s financials show its consistent ability to generate robust FCF despite a flat top-line. This has been achieved through modest capital requirements and tight operating efficiency. The business will produce $19mm of free cash flow in 2005 after $54mm of EBITDA, $15mm of capex, $12mm of interest, $8mm of taxes, and steady WC. Current equity FCF yield is 15% on a market cap of $122mm.


FY 6/30 2002A 2003A 2004A 2Q LTM 2005E

Revenues 447.3 446.9 445.4 435.3 427.1
Gross Profit 106.7 103.4 101.7 99.8 98.1
EBITDA 52.2 52.0 54.2 55.0 54.2
% Margin 11.6% 11.6% 12.2% 12.6% 12.7%
Capex (12.0) (15.6) (15.1) (12.3) (15.3)
Interest (17.2) (14.6) (14.2) (13.5) (12.2)
WC 8.6 (5.7) (5.8) (5.8) (0.3)
Tax (4.9) (2.4) (4.1) (4.7) (7.4)
FCF 27.2 13.6 15.0 18.7 19.0
NI (Adjusted) 9.7 10.6 12.4 13.9 15.0


As a note, unlike many other printers, the numbers above are organic- Cadmus has not relied on acquisitions to grow their bottom line.



DOMINANCE IN A STABLE MARKET
The Science, Technical and Medical (STM) market consists of 8,500 publications from 1,600 publishers and is largely supported by research funding (government and private) and association dues. This content is written and read by the academic community around the world. The company has over 600 customers and 2,200 titles, representing a 40% market share, that provide a stable and diverse cash flow stream. Growth going forward is expected to be steady from increasing demand for healthcare education and research.

Long-standing relationships, recurring revenues and cash flow, and a diversified customer base drive the company’s dominant market position. The company’s average length of top 10 STM customers is 25 years and over the last 5 years over 95% of its customers has been recurring. Approximately 85% of STM sales (50% of total sales) are under long-term contracts. The market is characterized by high customer retention with an average of three-year contracts and stable demand that yields a recurring revenue stream- switching costs are high because of the technical nature of the product and established relationships. Even amidst a weak economy in printing over the last few years, results have been stable as there is little dependence on advertising revenue (less than any other part of the broader publication market).

The company is not exposed to paper or postage cost over the term of the contract – it is all passed through to the customer. They do however gain scale on their smaller competitors by buying a million tons of paper a year. Management has hinted on recent conference calls that they believe there are ways to improve their current paper purchasing processes. We estimate this could result in ~$2mm of EBITDA for 2006.

The second largest player in the space is The Sheridan Group, which is approximately a third of the size of Cadmus in the STM market, but focuses on the short-run segment (production runs < 5,000 copies) instead of medium/long-runs like Cadmus. The company recently acquired The Dingley Press for $67mm in an attempt to enter the specialty catalog market. While it is a going concern for Cadmus that Sheridan may make an aggressive move into the medium-run market, this acquisition provides comfort that the company is first attempting to diversify into other niches.


PREMIUM VALUE PROPOSITION
This is the outsourced “one stop shop” value proposition for an STM publisher:
1) Content Management- proofing/editing, composition/data/image management
2) Production- printing, binding, mail, reprint
3) Distribution- back issue storage and distribution, cd-rom services

Editorial and other content management services are especially important to the STM market because it’s imperative that the highly technical content is correct- requirements a commodity printer are unable to fulfill. RH Donnelley attempted to enter the business in the mid 1990s but failed as the significant front-end logistics proved to be too high of a hurdle. Traditional printers earn 10% of sales from front-end logistics and 90% on the print run. Cadmus, on the other hand, generates 90% of sales in the first copy with only 10% remaining on the print run. Cadmus believes they have one of the largest groups of skilled copy editors in the world. In the end, overall content management represents almost two-thirds of the total journal sale. Associations typically do not have a dedicated publication department, and only a few printers can deliver the entire front end, printing, and back-end that associations demand. STM publishers are willing to pay a premium for the one stop shopping that Cadmus provides.

In the future, as electronic distribution continues to take share away from print, the role for Cadmus remains virtually the same. Cadmus has developed an array of proprietary technology platforms such as Article/KnowledgeWorks that provide solutions to issues such as digital rights management and online peer review. This expedites both production and distribution of the time-sensitive material as well as reduces production costs. Since Cadmus works with three-fourths of the top 100 journals in the country, these technology platforms are quickly becoming industry protocol.


IMPROVING OPERATING MARGINS
While the overall printing business climate has been difficult over the last few years, the STM journal market has performed considerably better than other forms of print (magazines, newspaper, catalogues) due to its low dependency on subscription sales and advertising. When compared to the larger printers, Cadmus has been very impressive with increasing its operational efficiency and keeping steady EBITDA margins despite the overcapacity and increasing commoditization of the printing industry.

2000 LTM
RR Donnelley 15.5% 13.0%
Quebecor World 16.5% 12.0%
Banta 12.5% 11.0%
Cadmus 12.5% 12.5%

Over 70% of the revenue decline has come from the company’s choice to moderate volumes for special interest magazine (~a quarter of total sales), a commodity like business that has historically only returned low single digit operating margins. The recent decision to roll off the low margin magazine business was intended to open up capacity for the move into the education space. This new business has ramped slower than expected, but the company has confirmed that the current backlog is strong. Last quarter the company signed a deal with Thompson Learning, and expectations are for similar deals in the future. So although the landscape for magazines remains competitive, it is encouraging that improved product mix will boost margins going forward and keep capacity open for higher margin education volume as the company gains traction.


SIGNIFICANT DEBT PAYDOWN
Five years ago debt stood at $246.0mm, including a $44.3mm off balance sheet AR securitization program. Since then, the AR facility has been completely retired. Current total debt is $161.5mm- representing a $84.5mm pay down in under five years. Total Debt / LTM EBITDA declined from 3.7x in Sept 01 to 3.0x today. Year-to-date the company has paid $6.3mm excluding swap agreements, and we expect at least another $8mm for the remainder of the year. Cadmus is the less levered than most of its comps, giving it solid financial flexibility: Sheridan 4.0x, VonHoffman 5.1x, RR Donnelley 5.5x, Vertis 5.9x, Cenveo (Mail-Well) 5.8x.


VALUE TO FINANCIAL SPONSOR
We think the enterprise value is worth at least $350mm ($20 share) to a private equity sponsor, and likely more to a strategic buyer.

Given the current accommodating bank and bond markets and low capex for the business, we are assuming 3.0x bank debt at L+350 and 2.2x of subs at 9.0%, implying $21mm of interest. Assuming a 20% required return would imply a $75mm equity value with $15mm of FCF.

EBITDA 55.0
Interest 20.8
Capex 15.0
Taxes 4.2
FCF 15.0

Sponsor Required Return 20%
Implied Equity Value 75.1
New Banks/Bonds 286.0
Enterprise Value 361.1

Less: Current Debt 161.5
Current Equity Value 199.6
Est. Share Price 21.34


CONCLUSION
Future risks as discussed include increased competition, digital migration, and a failure to grab educational volume. We believe that these risks are mitigated by the deep discount of the shares and the stable FCF the business generates through stable/recurring revenues and tight operating efficiency.

Catalyst

15% FCF yield- significant debt repayment of $15mm a year
Takeover- worth at least $350mm ($20 share) to sponsor, and possibly more to a strategic
Leveraging educational volumes- all upside to current numbers