Description
Cenveo (f.k.a. Mail-Well) is a 25% free cash flow yield stock with tremendous upside potential based upon expected improvements in cash flow, continued high returns on invested and incremental capital in its core businesses, and the ‘transfer’ of enterprise value to stockholders from debtholders via the aggressive paydown of debt.
CVO is the world’s largest envelope maker, one of the top 3 commercial printers in the US, and is the largest manufacturer of business forms/labels sold through distributors. The Company makes envelopes with other kinds of specialty packgaging for an array of purposes—direct mail, catalog mailing, billing, and medical records. Among the company’s commercial printing products are annual reports, brochures, marketing materials, maps, catalogs and greeting cards. CVO also produces business forms and pressure-sensitive labels. The Company owns and operates more than 90 printing and manufacturing facilities in the US and Canada. It competes with segments of RR Donnelley & Sons, Quebecor, Banta, and hundreds of other small US based printers and envelope makers (the US printing industry has 46,000 players, most of them very small).
CVO’s stock has done poorly over the past four years as the commercial printing industry was plagued with over-capacity and pricing pressures due to the worst advertising recession since the great depression (Sept. 11th a major contributor to this in addition to the economic recession). CVO also suffered from a highly leveraged capital structure, significant fixed cost base, perceived threats of digital/online advertising displacing direct mail as a viable advertising medium, and considerable “noise” with regard to asset dispositions and disposing/closing down unprofitable printing plants and businesses. Despite the company’s history of aggressive growth though acquisitions, its focus during the past two years has been on improving operating efficiencies and margins in the core Envelope and Commercial Print segments through closing 15 envelope and printing facilities, selling off non-core assets (office products distribution, adhesive labels, and filing products), headcount reductions (1,200 jobs cuts), and paying down debt.
**The Print Markets are Turning Around** - During 2001, CVO earned $156MM in EBITDA, which dropped to $121MM in 2002, which was the worst year in the Company’s operating history. The company’s operations are in the midst of a turnaround, as volumes are increasing, pricing has stabilized, and advertising spending, economic growth, and industry conditions are clearly improving. CVO has experienced 9 consecutive quarters of EBITDA growth, driven by higher volumes, market share gains, and benefits from the company’s past restructuring efforts. Revenues were flat in FY03 and have begun to rebound this year (4% revenue growth in 3Q04, up 1% on a YTD basis). The company is expected to generate EBITDA of $135MM-$140MM this year and $35MM in run-rate free cash flow (before acquisitions). In 2005 and beyond, the Company has the ability to generate $155+ MM in EBITDA as revenue increases coupled with the benefits of cost cutting will result in margins returning to normalized levels.
**CVO’s valuation is extremely attractive and its stock price will benefit from the operating leverage inherent in the business and through management’s commitment of allocating capital to pay down debt** -- With a $140MM market cap, its free cash flow yield is north of 25%, and it trades at an EV/EBITDA multiple of 6.6x ( below the historical industry trading range of 7.0 to 9.0x and on depressed EBITDA). Over the next three years, the company will generate a $140MM+ of free cash flow for debt paydown (did $21MM in free cash flow during 2002 prior to restructuring payments, the company’s worst year). With $140MM in debt reduction, leverage (currently at 5.6x EBITDA) will go down by 1.0, and assuming a static multiple on enterprise value of 6.6x, value accretion to shareholders would immediately double—even before factoring any improvement in cash flow.
**CVO’s balance sheet is now in good shape** as the company has paid down $350MM in debt since the beginning of 2000 (through asset disposals and free cash flow), 87% of the Company’s debt is fixed-rate (insulated from higher interest rates) and the next maturity ($78MM in bank debt) isn’t until 2008; $350MM in senior notes come due in 2012 and $300MM in senior subs come due in 2013. Here is a great example on how CVO’s leverage (operating and financial) can work to shareholders’ advantage as results improve: In 2004, management expects to generate a minimum of $135MM in EBITDA, which represents a 6% compound annual growth rate since 2002, the Company’s worst year, when EBITDA bottomed out at $121MM. Assuming a constant enterprise value multiple of about 6.6x, each 6% growth in EBITDA should increase CVO’s stock price about $1 per share, or 30% from its current market cap—and this is before assuming any debt paydown which will grow shareholder value much further). The 6% annual increase in EBITDA was performed in a market that didn’t grow in real terms and saw significant pricing pressures. All industry experts predict a much better 2005 and beyond as the economy improves, capacity continues to be rationalized, and pricing power is restored.
**Commercial printers deserve a higher multiple than 6.6x** Based upon the expected rate of return for this type of business, the requirements for and cost of capital, and the likely long-term growth of the business, CVO’s multiple will likely expand from its current level. CVO requires minimal capital spending (averages $25MM-$35MM) per annum, and generates high cash returns on capital (12% current run rate, expected to reach 15+% in recovery and in line with historical levels). While technological advances in communications such as fax machines, e-mail, the internet, interactive TV, and e-commerce have affected demand for printed materials, the reality is that we do not live in a “paperless society” and the printing business should continue to grow; industry experts believe that the industry will witness modest growth of about 2% -3%, roughly in line with GDP, for many years to come, most of which will be driven by ancillary services and digital printing. These are high-margin businesses in which CVO is a market leader and are growing at 6%-10% annually. The demand for print and graphic services continues to largely be a function of the health of the economy, and commercial print spending is beginning to pick up with GDP growth and higher ad spending (all commercial printing companies including RR Donnelley, Quebecor, Banta, Standard Register are reporting the same phenomenon).
One can assume that CVO’s required return on capital would be around 15%. This is derived by taking the weighted average cost of debt ($70mm on pre-tax basis on debt of $757MM or 9.2%) plus the weighted average cost of equity assumed as pre-tax cash flow yield on market cap (current equity market cap yield = 25%, or 37.5% on pre-tax basis). Multiply these by the weights of debt and market cap (85% debt times 9.2%, 15% market cap times 37.5%), to get a weighted average cost of capital of around 15%. Assuming that CVO will grow cash flow at an average of 2% a year and that required return on capital for CVO is 15% (pre-tax), then the implied pre-tax cash flow multiple is calculated as 1 divided by 0.13 (0.15 minus 0.02) or 7.7x; obviously, this is sensitive to the assumptions of growth rate and required return on capital, however these assumptions are pretty conservative, implying that CVO’s trading at a 6.6x pre-tax multiple of EBITDA is pretty low and that the average historical industry trading range of 7.0x-9.0x would be more reflective of the business economics and expected returns on capital.
**There is substantial room for EBITDA improvement-- over the next 3 years, EBITDA could surpass $155MM** CVO has undergone a major restructuring effort from 2000-2003, which involved focusing on its core businesses and optimizing operational efficiencies, to better offer a “one stop shop” solution for customers. CVO’s focus has been to create a leaner company that can quickly respond to customer needs and changes in the printing market and improve cross-selling opportunities. Its goal has been to offer all the benefits of a large national provider (including printing quality/color, consistency, high volumes, national distribution centers located in 34 states and Canada), with providing superior customer service at the local level. CVO has recently reported success in winning new contracts, including the US Postal Service, Starwood Hotels ($20MM annual revenues), and a major media company ($35MM), and American Express ($70MM annual revenues). CVO also completed two small printing company acquisitions (Valco Graphics in Seattle and Waller Press in San Francisco) for $10MM, which have revenues in excess of $32MM and management estimates that the return on these investments in 2005 will be 40%-50% (or $4MM to $5MM in EBITDA) as they are fully integrated with CVO’s operations.
With a conservative estimate of 5% revenue growth in FY05 from current run rate (in line with what most printing companies are expecting in 2005 and including the effects of two acquisitions) and a stable (unchanged from current level) EBITDA margin of 8%, EBITDA would be in the $145MM range. With a return to historical EBITDA margins of 8.5%, EBITDA would be in the $150MM-$155MM range, which is close to the same level witnessed in FY02. With $35MM in Capex, $70MM in interest expense, and taxes at the 34% level, free cash flow would be $40MM+ (25%+ free cash flow yield).
**Scenarios for stock price appreciation potential**:
1) EBITDA grows to $150MM -- Driven by ongoing turnaround; revenue increases and return to normalized margins. Assume multiple of 6.6x stays the same:
Result: Market Cap impact: $100MM.
2) Debt reduction of $140MM over three years:
Result: Market Cap impact of $140MM of wealth transferred from debtholders to equity holders, assuming constant 6.6x multiple on EV.
Multiple expands from 6.6x to industry historical average level of 7.5x as industry conditions improve and debt is paid down. Assume no change in cash flow ($135MM)
Result = Market cap impact +$121MM
Total combination of market cap impact : $100+$140+$121 = $361MM vs. current market cap of $140MM. Appreciation potential + 100%-160% over next three years.
**All major indicators show that commercial printing is really recovering**: Aside from CVO’s EBITDA growth over the past 9 quarters and FY04 revenue growth, The National Association for Printing Leadership (NAPL) Business Panel, a representative group of more than 300 printers than the association surveys monthly, reports that commercial printing sales are increasing and other indicators such as work-on-hand, and business confidence are also experiencing positive growth trends. As of July (latest public numbers available), the NAPL Business index has shown 13 consecutive months of positive readings (reading above 50.0), with a reading of 56.0—a reading above 50.0 means more printers report activity is picking up versus printers that report activity is slowing down; a reading below 50 means the opposite.
**E commerce and other advertising forms are facing significant threats that will benefit commercial printers**: The dire predictions of a “paperless digital society” have not materialized and even areas where benefits are obvious, such as electronic bill pay and presentment, the take rates for this technology have been much lower than expected. Also, with regard to the FTC’s “No Not Call List” legislation, commercial printers are reporting increased demand for printed advertising and direct meal as companies have shifted ad dollars from telemarketing to direct mail. Similarly, the anti-email spam movement is gaining popularity, with legislation possible over the next few years, and today there are several programs that block pop-ups or email spam that are gaining popularity. The near-to-intermediate term impact of electronic competition will likely continue to be minimal and traditional print media will be complementary to electronic media in the future.
Other Strengths:
** Company well positioned for Growth** Due to the extensive cost cutting and streamlining of its operations over the past three years, CVO has now integrated its disparate businesses into a unified national platform that is well positioned to capitalize on customer needs for a broad set of products and services with national distribution potential.
**Granularity in customer base: The Company has over 40,000 customers and no single customer accounts for more than 3% of the company’s sales (top 10 customers comprise less than 15% of total sales).
**Significant management ownership of stock & value-oriented stockholder base: Management and Wallace Weitz, Co. own 13% and 25% of the stock, respectively.
Weaknesses:
**Reliant on cost of paper: CVO, like all other commercial printers, have contracts with their customers that have the cost of paper as a pass-through, although it is with a 30-90 day lag period, which could squeeze margins if paper costs keep increasing in a very rapid fashion. Also, CVO has been able to insulate itself through better purchasing power with its suppliers; thus far rising paper prices have not had much of an impact on CVO this year or over its operating history.
** Sensitive to postage rate increases: CVO is also sensitive to postage rates, with direct mail customers demanding fewer mailings, envelopes, inserts, etc right after a postage rate increase. There are no postage increases proposed over the next few years, however, in the years where there is one, CVO’s revenues will be affected (in the past the company has been able to weather these events).
**Highly leveraged balance sheet: CVO has levered up to do acquisitions and got caught in the worst industry downturn with a high degree of leverage. While it was still able to generate free cash flow through the downturn, equityholders would have benefited if there had been a less levered balance sheet. However, the leverage in an upturn can actually have the opposite effect or “magnifying” the strengthening results, and the company continues to prioritize debt paydown--in effect transferring enterprise value to shareholders from debtholders).
** Cyclical company exposed to economic slowdowns. Commercial printers results track GDP pretty closely over time.
** Revenues are project-based: CVO, like many of its peers in the commercial printing industry, has customer contracts that are generally of a short-term nature and are based on individual projects—this tends to limit predictability when forecasting future earnings/cash flows.
Catalyst
Revenues and cash flow are expected to improve substantially over the next few years as the economy improves and margins benefit from Company’s rationalization/restructuring efforts
Pay down of debt at $40MM+ per year will accrete more enterprise value to shareholders from debtholders (market cap only $140MM).
CVO’s enterprise multiple will likely expand from current level of 6.6x to a level more in line with historical averages/peers, given the high returns on capital generated by its businesses.