Description

How would you like to short a company that has a mundane business which has been in perpetual decline for the past 10 years and a couple of catalysts that should further reduce earnings rather materially and thus speed up its demise? IKN trades about $10mm per day and the short interest is relatively modest at 6.9%.

Business: IKN offers digital copiers, multifunctional products, printers and print controllers for network and production copying and printing; enterprise services for various phases of the document lifecycle, including document capture, workflow, output, and retention phases; and professional services, which include the installation, configuration, and connectivity of digital network devices and document management software and solutions, as well as end user training, application customization, and help desk services. The company also offers on-site managed services, such as on-site fleet management of equipment and turnkey copy center and mailroom management solutions. In addition, IKN provides preventative maintenance and technical service support for office equipment and solutions. Further, it provides equipment lease financing through GE to its customers. The company's customers primarily include large and small businesses; professional firms; as well as state, local, and federal governmental agencies.

In FY1997, IKN had over $5.1 billion in revenues and an operating margin of 9.5%. In the TTM, IKN had less than $4.2 billion of revenues and an operating margin of 4.8%. There are a few main reasons why IKN’s business has been in constant deterioration for years and they are:

1)      More information is transmitted via the internet instead of printing documents and then sending them via USPS/FedEx/UPS. Just think about how the investment management industry goes about reading annual reports, research reports, SEC filings, etc. today versus 10 years ago.

-It is important to understand that this is largely a razor/razor blade business model. Little-to-no money is made by placing the copier/printer with the customer. The money is made on the “blades”, which is refilling the ink and toner as well as on servicing the machine when needed. Businesses still have about the same number of copiers/printers/fax machines they used to use, but their overall combined usage rates have simply declined. This trend should continue over time as the work-force age mix is made up increasingly of generations that grew up reading more on a computer and less on paper.

2)      More document storage of records is being kept paperless and the cost of doing this should only decrease over time, making this trend even greater as time goes on.

3)      As the cost of printers have continually come down, combined with the convenience of having a printer at one’s desk as well as the cost of ink and toner declining somewhat, more low volume printing is being done at one’s desk instead of at a centralized mega copier/printer.

4)      While it is difficult to quantify the exact amount, IKN appears to have lost a few percentage points of market share over the past 10 years and thus currently has about 10% share. IKN grew mainly through acquisition by buying up mom & pop shops, many of which would re-compete with them years later and thus take away sales IKN bought. In addition, there has been relatively high turnover within the sales force and one gets a sense after talking to a few sales people that they are not the happiest bunch since they continually lose sales to better competition at the local and national level.

 
With the exception of serving large corporations, IKN has no real competitive advantage. This is a localized business in that mom & pop shops can sell copiers/printers at a similar price compared to IKN or any other distributor/retailer and compete on providing better service. When it comes to serving small-medium sized business, this business is all about scale within a local area. This is why IKN has made a much greater push towards moving its business more towards Fortune 500 companies and less to the small-medium sized business. Unfortunately, an improvement in customer mix towards larger corporations will not really improve its future prospects since its biggest competitor across the board, Xerox, has recently become much better for two main reasons that tie into each other:
 

1)      It acquired arguably the best U.S. distributor, Global Imaging, in early April, 2007. Global, which used to distribute Xerox’s as well as other manufacturer’s copiers/printers is simply having the Global sales force sell Xerox products where it used to push other manufacturer’s products. Unlike IKN, Global Imaging’s sales force has low turn-over and is known for having long-standing relationships with its customers.

2)      After the close on Monday, September 24, 2007 Xerox said it “will cut the price of color copying by two-thirds, sweeping away a major hurdle for customers seeking to enter the profitable and growing color market”. Xerox is set to accomplish this feat via new printers and updated solid-ink technology. These “new printers use longer-lasting crayon-like ink sticks that will help reduce the cost of printing...In development for nearly five years, the new ink sticks are now larger and more dense…Together with the new machines, the ink will cut the cost of color copying and printing from the 15 cents a page to 5 cents,” which is equal to the price of black-and-white printing. While these printers will cost about $900 more upfront compared to equipment handling the same volume (2,000-10,000 pages printed per month) sold by competitors, Xerox claims the per page savings will pay for itself in about five months.

 
Let’s get to the numbers (all TTM), which I used for this analysis:

 
Price (9/28/07): $12.85

Shares Outstanding, diluted (in mm): 126.6

Market Capitalization: $1,626.3mm

Cash and equivalents: ($287.3mm)

Total Debt: $807.9mm

Enterprise Value: $2,146.9mm

EBIT (D&A = maint. capex): $198.5mm—results in a pre-tax return on EV of 9.3%.

Net Income: $113.2mm (tax rate is 32.7%).

EPS: $0.89—results in a P/E of 14.4x.

While the valuation is likely full, it does not appear extremely rich for a distributor. We believe the odds are very likely that the future earnings power of this business will be much less than it appears today and that as a result the P/E multiple that the market will afford IKN will be closer to 10x. After all this is a company that has a perpetually declining business coupled with some leverage.

Negative/Potential Negative Impacts to EPS:

1)      It is important to know that GE provides financing to IKN’s customers when they choose to lease a machine instead of buying one. The final negotiations this past year resulted in GE paying IKN $17.0mm less in financing fees by the end of 2012. The present value (using a 10% discount rate for 4 years) negative impact is $0.06/share. Since this is guaranteed to happen the negative impact must be considered for all scenarios.

2)      The effect of Xerox’s Solid Ink Technology could be devastating to IKN’s business if the quality is close to or as good as the quality of color printing that people are used to. By cutting the price of printing a color page by 66.7% from $0.15 to $0.05, in-line with the cost to print black & white, this at a minimum should take industry pricing down for color. At the same time we believe IKN could lose sales to Xerox. Since IKN’s lease contracts have an average life of 4 years, customers will constantly be up for renewal every year. Also, keep in mind that the customers most likely to leave IKN and/or shift color printing to this new Xerox machine and/or demand better pricing for its next contract are its most profitable customers since they print the most color and would thus stand to benefit the most from Xerox’s new technology. If we assume that IKN will lose 3% of sales at an incremental operating margin of 10% over 4 years, or 0.75% of sales per year starting in 2009 the present value of that negative EPS hit is $0.05.

3)      Out of the approximately 88.3 billion pages IKN’s customers print each year, 2-3% or about 2.1 billion pages are printed on analogue machines. IKN makes more $0.02 more per page from an analogue copy versus a digital copy. However, this piece of IKN’s business has been declining at a rate of 35% per year and is expected to do the same going forward. This provides an incremental $14.6mm in revenues and at a 60% gross profit margin on this incremental revenue could result in a negative $0.05 impact to EPS if the same decline rate occurs for the next twelve months.

4)      Over the past 6 years from 2001-2006 the average trade loss provision as a % of sales was 0.18%. In 2006 trade loss provision as a % of sales was 0.06%. Relative to its average, this potentially boosts TTM EPS by $0.03. While I do not count on this for my short thesis, it is one more potential red flag. Also, note that the ending trade allowance balance as a % of gross trade receivables was 1.9% at the end of FY2006 while it has averaged 2.9% over the past 6 fiscal years.

5)      Inventory as a % of sales over the past 10 years was 6.7%. As of 6/30/07, inventory as a % of TTM sales was 7.6%. The company claims the reason is that it opened another DC and that in order to maintain the same level of service to its customers it had to beef up inventory levels. Even if one believes this to be true, there is a still a risk that some of its inventory is stale and thus the gross margin it can conceivably get on its products may be lower than normal. While the total negative impact is negative $0.20, we took the view that this should be amortized over 10 years as it may be a structural change in the business model in that it simply needs to hold more inventory to remain competitive from a servicing standpoint. Thus we estimate this could be a negative $0.02 impact to EPS. Clearly, one can take the view that this simply should be a $0.20 write-off, and we consider that view for IKN’s bull case.

Potential Positive Impacts to EPS:

1)      IKN began selling the Canon C7000, which is a heavy duty copier for printers. So far the response has been fairly positive. If it is able to sell 271 of these units at an average selling price of $285,000 and get a 28.4% operating margin, this could result in a $0.12 EPS benefit.

2)      One of the major bull cases for IKN is that more of its customers will print color versus black & white. Today only 4% of IKN’s pages are printed in color while only 8% of its machines placed with customers have the ability to print color. If we assume that the same economics remain (i.e. $0.15 per color page versus $0.05 per black & white page), a continual positive mix shift could result in a $0.07 EPS benefit from equipment as well as ink and toner sales.

3)      Theoretically IKN could grow its installed base even though in the past three quarters equipment sales have declined by 1.0%. However, if we assume equipment sales grow at 0.6% per year at an incremental operating margin of 15.0%, this would result in a $0.01 EPS benefit.

Best Case (for EPS): $0.89 - $0.06 (lower GE financing fees) + $0.12 (Canon C7000 sales) + $0.07 (increased color printing at prevailing economics) + $0.01 (increased sales): $1.03. Applying a 15x P/E multiple on $1.03 = $15.45 or 20% upside.

Worst Case (for EPS): $0.89 - $0.06 (lower GE financing fees) - $0.05 (Xerox’s Solid Ink Technology potential impact) - $0.05 (analogue to digital impact) - $0.03 (unsustainably low provisions for bad debts) - $0.02 (inventory issues) = $0.68. If we apply a 10x P/E multiple on $0.68 = $6.80 or almost 50% upside.

Thus the reward/risk is about 2.5x. I believe the Xerox EPS impact could be much worse than $0.05, which could make the reward/risk better than I assume for my short thesis.

Disclaimer: The firm and its affiliates that I work for may or may not be short IKN. This is not a recommendation to buy or sell securities. Please do your own work and come to your own conclusions regarding IKN.

Catalyst