Description

DLAR is the world leader in supplying outsourced banknote production to national governments. The banknote industry is complex, secretive, and poorly understood. Conventional wisdom would hold that banknote production is a mature, slow- to no-growth business. The “plastic penetration” of credit and debit cards garners significant attention. However, we believe that the banknote business is surprisingly robust. We have learned that banknote usage continues to grow steadily in the most developed economies and is accelerating in the emerging markets where DLAR does most of its business. Further, DLAR, along with its competitors in the banknote business, enjoys exceptional barriers to entry. Outsourced banknote providers supply a mission-critical product to an extremely risk-averse customer base: national governments. New entrants are virtually unheard of due to the high upfront capital requirements, the need for esoteric technical expertise, and the fiercely competitive incumbent participants. Because DLAR is the sole public competitor in this industry, we believe that investor awareness is limited. The industry insiders with whom we have spoken have reinforced this conclusion – most of them have never been contacted by public equity investors.

            DLAR has benefited from a proactive management team focused on streamlining the business model and returning money to shareholders. In September 2008, management completed the sale of the Cash Systems division, which was lower margin and more cyclical than the core currency business. The after-tax proceeds of this sale were returned to shareholders through a special dividend. CEO Leo Quinn recently announced his retirement, but the company should be in good hands under the leadership of James Hussey, the new CEO and former MD of Security Paper & Print, along with Stephen King, who will continue as CFO.

DLAR offers an unusual opportunity to increase exposure to emerging market growth while avoiding its traditional risks: banknote production is one of those rare industries that benefits from political instability. Indeed, DLAR offers valuable embedded options on the possibility of political upheaval. This upside is supported by a predictable earnings base: the current backlog stretches 12 months, and counterparty risk is relatively low: currency purchases are nearly always a non-discretionary expenditure for DLAR’s government clients. 

Based on our projections for the fiscal year ending March 2010, DLAR currently trades at ~7.5x EV/EBITDA, and offers a free cash flow yield of ~9%. With little net debt (<.5x EBITDA), DLAR retains significant financial flexibility.

Company

DLAR was founded in 1813 and started supplying banknotes in 1860. In 1994, DLAR acquired Portals, papermaker to the Bank of England since 1724. With the Portals acquisition DLAR became a vertically integrated banknote provider, capable of handling both the paper and printing requirements of banknote production. DLAR solidified its position by acquiring the Bank of England’s printing works in 2002 and since then has been the sole supplier of sterling notes. Today, DLAR remains the leader in outsourced banknote production and supplies currency to over 150 countries. DLAR’s papermaking ability is a critical advantage that differentiates it from smaller competitors. With its in-house paper supply, DLAR can react efficiently to customer needs, especially when unpredictable, high-margin “overspill” work arises.  DLAR’s reputation for superior execution has been demonstrated repeatedly with marquee assignments. One of these was Iraq: after the fall of Saddam Hussein, DLAR was chosen to supply the new currency, a complex and sensitive undertaking. To take another example, Nigeria, a country with in-house banknote production facilities but with near perennial “overspill” requirements due to a growing population and a volatile, commodity-based economy, has consistently turned to DLAR for its emergency banknote needs.

            Following the spin-off of Cash Systems, DLAR is organized into four divisions: Currency, Security Products, Identity Systems, and Cash Processing Systems. Through the currency division (~85% of operating income), DLAR conducts its world leading banknote business with close to 50% of the available market. Security Products (~12% of operating income) provides product authentication devices for customers including Microsoft. Identity Systems (~3% of operating income) designs and produces passports and various other identification documents. Cash Processing Systems (~0% of operating income) provides large-scale banknote sorting machines for central banks – it is considered integral to the currency franchise, and thus was the only component of the legacy Cash Systems business to be retained.

Industry

The banknote industry is predictably opaque – national security concerns of the customer base necessitate discretion. However, through various conversations we have learned that it is a competitive, rational market, albeit one with limited participation. DLAR and its primary competitor, a private German concern called Giesecke & Devrient, dominate the market. A French company, Francois Charles Oberthur Fiduciaire, is a distant third, and a smattering of smaller players round out the field. The largest projects are the exclusive domain of the top three, while the smaller participants fulfill the limited requirements of their various niches. DLAR and G&D stand above the rest due to their in-house paper making capacity. This vertical integration allows them to fulfill customer orders without the paper supply concerns that plague the competition. Integration is also becoming increasingly important as security features embedded in the paper must be coordinated with printing features. As such, DLAR and G&D enjoy a massive competitive advantage. After many conversations with industry insiders, we feel comfortable that the current supply/demand environment is tight and should remain so for the next several years. Moreover, maintaining the supply/demand balance is clearly a critical interest of the powerful industry oligopoly.   

Demand trends for banknotes are complex and vary by country. Key drivers include population growth, nominal GDP growth, increasing velocity of money (often the result of increasing numbers of ATM and other cash handling machines), and clean-note policies (again, required by automated cash handling infrastructure). Banknote durability is a countervailing factor, usually increasing the price and profitability of individual banknote orders, but slowing banknote volume demand. Our industry contacts hold a consensus view that world growth rates will continue at their historical average of 3-4% for the foreseeable future. However, we believe that 5% is a conservative growth estimate for DLAR’s market, and the true growth rate could be significantly higher: most of DLAR’s customers are emerging economies with higher than average GDP and population growth. Furthermore, the demand curve in these countries is shifting higher due to the proliferation of cash automation systems and more frequent note redesign. In 2006 the number of ATMs grew by 15% in India, by 13.2% in China, and by close to 25% in Eastern Europe.

The supply side is more predictable because capacity addition requires significant investment and multi-year lead times. Our diligence conversations lead us to believe that there is low risk of significant unforeseen increases to supply over the next few years. Further out the view grows murkier, but there should be timely warning for the investor who stays abreast of market developments. This tight supply base in the face of robust demand growth should lead to increasing pricing power over the next few years. While our projections are not dependent on major price increases, the likelihood of strengthening pricing further bolsters our thesis.

Valuation

Considering the resilience of the banknote market and DLAR’s clear competitive advantages, valuation levels are highly attractive. Our projections imply a free cash flow yield of ~9% for the fiscal year ending March 2010.

Catalyst