Description

Authors Note: This note is little thinner than my prior posts, but I felt the opportunity was pressing. I would happy to delve into further detail in subsequent updates with any VIC members.

Date: 5/4/04
Company: IKON Office Solutions (IKN)
• #2 Copier company in US; Sole distributor of Canon and Ricoh products in North America.
• Leasing/finance had been a major earnings contributor; IKN sold this biz for cash to GE Capital; Market expects cash received to be used for share buybacks and acquisitions.

Action/Price: Buy at $10-12.

Upside: $15-18, based on a normal multiple of 15-18x P/E.
• By 12/04, IKN will have $1 billion Cash having sold substantially all its leasing portfolio to GE Capital.
• IKN has guided to $0.75 2004EE’s; this guidance excludes ANY benefit from the $600mm-$1 billion of cash at its disposal by year-end 2004.
o This guidance was below Analyst expectations, but analysts readily acknowledged they had little faith in their own estimates b/c they did not know what the uses of cash stemming from the GE deal would be.
• IKN has guided that they will invest $600 mm (minimum) in the business, much less than its $1 billion.
• Option #1: Assume IKN buys $600 mm worth of shares at $12 shares; adds $0.30 share to EPS.
• Options #2: Assume IKN buys $250 mm worth of shares at $12 share (+ $0.13/share), and $350 mm in acquisitions should add $0.20/share.
• Net net, fully invested of the minimum amount of cash IKN has to invest, IKN should earn at least $1.05 to $1.08/share.
• Pro Forma for the sale, IKN should produce $1.00 to $1.30 of FCF per share in 2005 and thereafter.
• We estimate IKN will in fact have $800-$850 mm Cash to invest in the company, not the $600 mm guidance.

Downside: $9, 12x IKN’s 2004 EE’s of $0.75
• Assuming the market ignores IKN’s $1 billion year-end cash balance, IKN should earn (at least) $0.75 on its existing businesses.
• At a minimum, market should award IKN a multiple of 12x, equivalent to EK’s multiple, despite the fact that IKN’s business is growing and strong and EK’s is in decline.

Summary:
• Background
o August 2002, Matt Espe joins IKN as CEO from GE.
o December 2003, IKN announces sale of substantially all of its Office Products leasing Portfolio to GE Capital – freeing up $600 mm - $1 billion. ($4.00 -$5.50 per share).
• Why is the stock down?
o #1: The market is ignoring IKN’s cash.
o #2: Undoubtedly, some investors likely expected a Dutch Auction to be announced.
o #3: Some investors expected a “guide up” not a guide down.
 Important: Guidance is strongly tied to managements assumptions.
 How much stock do they actually buyback?
• IKN has indicated about $250 mm would be target for share buybacks, but does not include the EPS benefit in guidance(!).
 What is the profile of the Leasing business?
• IKN has indicated their lease portfolio is very quality and experienced very few losses.
• We strongly believe IKN, in classic GE style, has over-reserved for leasing losses (and under-guided the street).
o #4: Poor sell side coverage & Company IR.
 Lehman, Soleil, and Goldman all cover IKN; All are strong at Copier fundamentals but IKN presents a highly complicated finance transaction.
• Catalysts
o May 25 – IKN Analyst day in New York. IKN should submit greater detail on their planned investments, return hurdles, etc.
o Acquisitions – spending the cash.
o Beating EE’s – we believe guidance is very beatable.
o Office Products Conference – 2 Major conferences this summer.
• Final Point: IKN is FLUSH with cash ($4.00-$5.50/share) and not expensive. Business IS getting better. Q1 was 1st positive Q for revenue growth in 6 quarters. Office products are late cycle.

Catalyst

Catalysts
o May 25 – IKN Analyst day in New York
o Acquisitions – spending the cash.
o Beating EE’s – we believe guidance is very beatable.
o Office Products Conference – 2 Major conferences this summer.