Description

Investment Thesis

Ennis Inc. (NYSE:EBF) is a short. The Company is in secular decline yet trades at 15x forward P/E. I expect EBF’s multiples to compress in the coming quarters following the recent divestiture of the Company’s Apparel division, leaving only the Print division, which is in secular decline and creates a simpler short thesis. In recent years the Company has propped up the Print division’s sales through acquisitions, which can only continue to the extent there are additional acquisition opportunities available. The pace of acquisitions has already slowed down in the last year. Going forward, to combat the decline in organic sales, management will need to continue making acquisitions. Management has historically paid 5-6x EBITDA for its acquisitions. Assuming management has already purchased many of the companies it would like to (i.e. good businesses that can be bought at fair prices), then to keep the pace of acquisitions the same going forward in order to prevent earnings declines, management will either need to pay higher multiples for similar quality companies or lower its quality requirements and acquire worse businesses. Either scenario is not ideal and will likely destroy shareholder value. Overall, I believe a business with EBF’s prospects should trade around 5x EBITDA, 10x P/E, and 8x FCF, implying ~32% downside to the current share price and 47% upside for the short. I believe the short opportunity exists in part because the Company is not very well known given it is fairly small ($500 million market cap), has limited research coverage, and does not have quarterly earnings calls/investor presentations.

Business and Financial Overview

Through its Print division, Ennis manufactures, designs and sells business forms and other business products primarily through independent dealers in the United States. The print business has been in secular decline as more and more businesses transition towards paperless forms of business. The Print division operates 58 manufacturing plants throughout the U.S. in 21 states. EBF claims ~96% of its business products are custom and semi-custom products, made on an individual job basis depending upon the customers’ specifications. While custom products may be slightly more resilient than standard products, both are in secular decline and therefore custom products do not offer much downside protection. EBF’s products include snap sets, continuous forms, laser cut sheets, tags, labels, envelopes, integrated products, jumbo rolls and pressure sensitive products. In the printing industry, sales occur either to end users like R.R. Donnelley, Staples, Standard Register, and Cenveo (direct), or through independent distributors and distributor groups (wholesale). EBF operates in the latter category and is estimated to be the largest player in the U.S. wholesale market and three times the size of its next competitor. The independent distributors and distributor groups compete with the office supply stores, and to the extent the office supply stores gain share, EBF’s business will suffer. Note the printing business is not seasonal and its key raw material is paper.

Given the secular decline of the printing industry, management has only been able to show growth by relying on bolt-on acquisitions, whose sales typically decline after purchase given management has not made acquisitions outside the printing industry. EBF has substantial market share and management believes the Company is the largest producer of business forms, pressure-seal forms, labels, tags, envelopes, and presentation folders in the U.S. distributing primarily through independent dealers. If this is the case, then growth will likely slow or turn negative in the coming years as EBF is already the number one player, has already consolidated the space quite a bit, and the overall market is not growing.

Ennis also had an Apparel division which sold activewear and which the Company announced the sale of last month. The Apparel division was a struggling business that posted negative to flat sales in each of the last four years with the most recent quarter being down 15% year-over-year.

While EBF may not appear overly expensive trading at 12x forward levered FCF, this metric does not capture the majority of capital spend, which has been acquisitions, not capex. The acquisitions in the last five years have all been for the Print division, which without acquisitions would show substantial declines. Over the last four years, EBF generated $190 million in free cash flow. Factoring in $130 million of acquisitions results in $60 million of true free cash flow, or $15 million per year simply dividing by four. Based on the Company’s current market cap, $15 million of FCF per year post-acquisitions implies a 34x multiple, hardly cheap. During the last twelve months, the Company generated $88 million of free cash flow before acquisitions and $72 million after acquisitions, implying a 7x free cash flow multiple after acquisitions. While this may appear cheap, note that out of the $88 million, $28 million was from a reduction in inventories. Without this favorable working capital adjustment, free cash flow post acquisitions would have been $44 million, implying a FCF multiple of 11x.

Over the past 54 months (since June 2011), the Company spent $135 million in acquisitions, all for the Print division. The Print division’s LTM sales as of May 2011 (so before the $135 million in acquisitions) were $272 million. The Print division’s LTM sales as of November 2015 were $391 million, an increase of $119 million, or 44%. EBF provides the revenue contribution of each acquisition at the time of purchase (EBF does not disclose the earnings). Therefore, we know that the $135 million in acquisitions contributed $202 million of sales at the time of purchase. Assuming that number has stayed flat implies a sales decrease for the base business of $83 million ($119 million less $202 million), or a 30% decline (negative $83 million divided by $272 million) over the last 54 months. As a result, the Print division has been experiencing an average annual decline in organic sales of approximately 8%. In reality, the recent acquisitions have likely also had declining sales, so the 8% annual decline in the organic business is more likely in the neighborhood of 5-7% with the remainder of the decline coming from the acquisitions. In fact, EBF’s most recent 10-K provides enough data for one to calculate that the Print division’s organic sales have declined 5% in each of the last two fiscal years.

Valuation

Before adjusting for the sale of the Apparel division, EBF has a market cap of $504 million, cash of $10 million, debt of $40 million (all revolver), and an enterprise value of $533 million. Note the cash and debt balances are as of February 2016, which is the Company’s fiscal year-end. Last month, EBF announced the sale of its Apparel division for an aggregate purchase price of $88 million, $76 million of which is cash at close and $12 million of which is to come over a five year capital lease plan, which I discounted over five years and assumed is cash at close for simplicity. The Company estimates the Apparel division will record a pre-tax loss of $73-79 million on the sale and should receive a tax benefit of ~$25 million as an offset to this loss, which I consider cash at close. I calculate total sale proceeds of roughly $111 million, which I am assuming is cash at close. Capturing this cash, EBF’s pro forma cash is $121 million, total debt is still $40 million, net debt is -$81 million, market cap is still $513 million (the market cap did not move much upon announcement of the Apparel sale), and the pro forma enterprise value is $422 million.

EBF pre-announced Q4 earnings a few weeks ago and guided to a very narrow range for where earnings would come out. In my model I have the Print division in FY2016 (again February year-end) doing $385 million in sales and $116 million in gross profit (30% margin). In FY2017, I assume no acquisitions and that the Print division’s organic sales decline 5% similar to in FY2015 and FY2014. The Print division’s long-term average gross margin has been 29%, and I assume 50 bps of gross margin compression from 30% in FY2016 to 29.5% in FY2017. I estimate EBF will have ~$18 million of corporate SG&A in FY2016. I assume with the sale of the Apparel division, management can cut SG&A by a third in FY2017 to $12 million (the Apparel division accounted for approximately a third of EBF’s total sales). Therefore, for FY2017 I estimate sales of $366 million, gross profit of $108 million, EBITDA of $61 million, EBIT of $49 million, net income of $30 million, EPS of $1.17, and levered FCF of $43 million (this assumes maintenance capex of $5 million and no acquisitions).

My EBITDA and EPS estimates for FY2017 are ~10% below consensus. EBF is currently trading at 6.4x and 7.0x consensus FY2017 EBITDA and my FY2017 EBITDA, respectively. I think a fair EBITDA multiple for a business in secular decline like EBF is 5x. Print companies today trade between 4-6x EBITDA. For example, RRD and QUAD trade at 5.6x and 4.4x forward EBITDA, respectively. One could argue for a lower multiple like 4x where companies like OUTR currently trade. However, I think 4x is too low a multiple because EBF, while experiencing a secular decline, is more of a melting ice cube rather than a company whose prospects are about to fall off a cliff. In comparison to OUTR, EBF’s organic sales are declining 5% compared to OUTR’s 10%. In addition, OUTR’s management has a poor track record of allocating capital in that most of OUTR’s FCF generation, which has been substantial, has gone towards bad acquisitions or share buybacks which have destroyed considerable shareholder value. In comparison, EBF has a track record of buying companies that are actually profitable and at fairly reasonable prices. Most of EBF’s FCF has gone towards acquisitions, with the rest being used for dividends and the occasional buyback. Therefore, I don’t think EBF should trade below a 5x EBITDA multiple unless revenues start to decline faster than expected and/or management starts overpaying for acquisitions in order to keep the business growing. At 5x my FY2017 EBITDA estimate, EBF’s fair value per share is $14.94 versus the current share price of $19.54, implying 24% downside.

EBF is currently trading at 15.0x and 16.7x consensus FY2017 P/E and my FY2017 P/E, respectively. My target P/E multiple is 10x, resulting in a share price of $11.68, implying 40% downside. Note GME/OUTR trade at 7-8x forward P/E, and I am applying a premium multiple to EBF. RRD, which is a much larger company than EBF, currently trades at 10.3x forward P/E.

EBF is currently trading at 11.8x my FY2017 levered FCF/share estimate of $1.65, implying an 8% FCF yield. EBF should trade around 8x levered FCF, or a 12.5% yield. An 8x multiple implies a share price of $13.23, resulting in 32% downside.

Averaging the three methodologies results in 32% of downside in the next 12 months. Therefore, shorting EBF today could result in a 47% upside over the next 12 months.

Conclusion

EBF is an attractive short with 47% upside over the next 12 months. The sale of the Company’s Apparel division acts as a catalyst in creating a simpler company and short thesis. Management has relied on acquisitions to grow the Print business. Unless management can keep up the pace of acquisitions, which has already slowed in recent quarters, EBF will start to show earnings declines which will change the market’s perception of the stock and potentially cause substantial multiple compression.

Catalyst

Completion of sale of Apparel division

Slowdown in bolt-on acquisitions