Description

Danka Business Systems (DANKY)

If IGI generates so much interest, why not look at DANKY?

Danka Business Systems supplies photocopiers, photocopier services, parts and supplies, and office imaging equipment directly to customers in approximately 30 countries. The company trades at 3.4x EBITDA, with solid free cash flow currently and a much improved balance sheet. The low valuation is due to the company's historic high debt load (in June of 2001, the company sold off a division that enabled it to make a principal payment that helped stave off bankruptcy), its status as a company in transition and, as with IKN, for example, the fact that it has become totally neglected by investors until it can prove it has stabilized. The debt is at more than manageable levels now and the company is gaining traction in the industry. This is probably the cheapest way to play the sector, a more leveraged and riskier version of IGI (albeit with differences in the business model), IKN, GISX, etc., with lots of room for multiple expansion and regardless, with an opportunity to create significant shareholder value through free cash flow generation and debt paydown.

I refer you to the writeup on IGI and the 10-k for industry and business information. In reality, all of the office equipment suppliers are fairly comparable, ex differences in the importance of certain product lines, sales techniques, services provisions, etc. For example, while DANKY has created a proprietary software offering in an attempt add more value to its part of the food chain, I am not sure that this kind of microanalysis is that important to an understanding of the opportunity at hand nor the realization of value. Some businesses are exposed to weaker lines, etc, but in my opinion, these are not great businesses, period. However, I think that is understood. Were the investment return to be dependent on the various micro management issues, I would find these opportunities much less compelling. Rather, consider DANKY as one of several FCF/debt paydown/turnaround menu choices based on your desire for risk/reward. The valuation cushion here appears enormous and the downside seems fairly limited, ex an understanding of balance sheet risk. Personally, I'd rather just view this for what it is -- a leveraged call option with enormous upside and the potential to bust. But in these cases (medicre businesses, lots of moving parts, etc., I find that doing analysis on margins, on product lines, etc. kind of misses the whe whole binary investment case).

Valuation

Cash: $47 mill
Debt: $342 mill
EBITDA: $120 mill for the next next 12 months

Assumes that company’s most recent quarter EBITDA is average for next 12 months – all indications are that revenues should be in line with industry projections for 5-10% declines and that EBITDA should at least remain stable [I assume no growth] in the foreseeable future. The company has already achieved significant cost savings and most of the operational turnaround and the balance sheet strengthening has been completed.

Fully Diluted Shares: 62 million
EV / EBITDA = 406/120 = 3.4x
Capex = $30 million -- significant excess depreciation on the books.
FCF = $90 million -- huge free cash flow yield.

Summary/Catalysts:

1) This is an opportunity to play a call option on the economy and a trade to a more reasonable parity with other suppliers, with little valuation risk and with defined principal loss risk. Prior to the sale of the DSI, Danka was a potential bankruptcy candidate. Since that time, the company’s balance sheet has strengthened and it has improved its EBITDA and free cash flow in each successive quarter. Debt has been cut in half. Interest payments in the last quarter were approximately $8 million, which were more than adequately covered by EBITDA, with plenty of cash left over for nominal cap ex investment and significant debt paydown.

2) Management has stated in private conversations that they want to tell their story to the street as soon as this fourth quarter is completed. All operating statistics have now improved over the prior year, and a turnaround is clearly underway. They intend to do an informational roadshow in April.

3) Insiders have been buying stock.

4) The competition, IKN, IGI, and GISX, are trading at significantly higher valuations. These companies have already turned the corner. DANKY looks eerily similar to these situations from one year ago.

5) Re downside protection, Danka’s business is not going away entirely –- it is a service business that generates significant free cash flow. Look for more announcements similar to the recent Staples announcement to add to the company’s stable revenue and FCF base, for example.

Assuming that revenues continue to decline in the 5-10% range and that EBITDA stabilizes at these levels (although EBITDA has been improving sequentially for several quarters), DANKY one year out will have debt of approximately $250 million. But let’s assume a difficult case and that EBITDA declines and stabilizes at $100mm per year. Assuming say, $280 million in debt one year out and no multiple improvement implies a stock price of $1.50. This is somewhat of a binary opportunity right now, because clearly, were the industry and the economy to deteriorate significantly, DANKY could easliy trade back to sub $1 levels and its balance sheet might begin to present problems again. However, the company appears to have put liquidity issues behind it and thus, I assume that in a reasonable downside case, DANKY just sort of wallows around, continues to pay down debt, never gets noticed, and we all just curse the dead wood phenomenon once again. In a reasonable base case, I believe this gives us a very real chance to make 3-4x our money over the next 12-18 months. If we assume that DANKY continues to hit plan (which it has done for 3 straight quarters now) and trades at a modest 5.0x EBITDA multiple, then a target price one year out of approximately $6+ per share appears quite reasonable. It may seem a bit absurd, but if you go back and look at the histories and charts for IKN and GISX, the stories are similar and investors were richly rewarded in those cases for taking early, defined risk. I'm willing to lose 50% of my principal in exchange to make multiples of that in a very short time frame, in which the assumptions that I make appear quite reasonable.

Catalyst