Description

If you own a removable storage product, such as a pack of recordable DVDs or an external hard drive, you've probably heard of Imation. The company owns the Imation and Memorex brands and has long-term rights to the TDK Life on Record brand. At $8.78 per share, Imation offers an attractive risk-reward, in our view. The market seems to be ignoring Imation's earning power, which has been obscured by litigation-related expenses and restructuring charges. The company's Q3 GAAP EBIT was only $1.7 million even as adjusted EBIT was a more meaningful $9.2 million. Once investors start giving Imation credit for the company's underlying earning power as well as the quality of its balance sheet, Imation should be revalued.

Strong Market Share, Global Exposure

Imation is a leader in optical storage and magnetic tape, with additional growth opportunities in new markets such as external hard drives. The company's products are aimed primarily at consumers and small businesses, with 49% of sales coming through distributors and 43% of sales generated from retailers last year.

Sales of optical products have grown from 35% of revenue in 2005 to 49% in the first half of 2009, as magnetic tape sales have declined from 56% of revenue in 2005 to 28% in H1 2009. Meanwhile, sales of emerging products have grown from 4% in 2005 to 18% in H1 2009.

Imation is a global company, with Americas sales (including North and South America) accounting for only 38% of revenue in H1 2009. Asian sales have grown to nearly one-quarter of revenue, giving shareholders of Imation a relatively conservative way of participating in the growth of emerging markets.

Recent Performance: Unexciting But Not Disastrous

Imation sales have suffered from lower consumer spending in recent quarters, with Q2 revenue down 22% versus the same quarter a year ago (flat sequentially from the first quarter). Excluding a litigation settlement and restructuring charges, Imation reported slightly positive operating income in the second quarter. This was driven by management's focus on cost containment, which resulted in a decline in SG&A expense from $73 million in Q2 2008 to $60 million in Q2 2009.

Management stated on the most recent earnings call that the "vast majority" of legal expense would go away due to the recent litigation settlement with Philips. Litigation expense amounted to $13 million, or 10% of SG&A expense, in H1 2009. Excluding litigation expense, Imation earned adjusted operating income of nearly $8 million in Q2, hinting at the company's profit potential.

In Q3, Imation had operating income excluding restructuring charges of $9.2 million, once again showing the earning power of the business. The company generated cash of $22 million in Q3.

Some Things to Consider When Valuing Imation

Imation paid $332 million for Memorex in 2006, approximating Imation's enterprise value today. This suggests that the Memorex acquisition likely destroyed value, but also that Imation may be undervalued today. The company has a market value of $362 million, adjusted net cash of $40 million, and tangible book value of $535 million. Imation generates sales of $2 billion and gross profit of $300 million. Earlier this decade, Imation was earning operating income of $100+ million in a "normal" year. The addition of Memorex should have grown this number, but profitability evaporated due to the recession and related execution issues.

Whether Imation can generate more than $100 million of operating income on a normalized basis in the future remains to be seen. If Memorex earns anything close to what might be reasonably expected given the $300+ million acquisition price tag, Imation should at least earn $100 million in total when the economy improves.

We judge Imation shares to have strong downside protection due to (1) a solid balance sheet with no debt; (2) shares trading 30% below tangible book value and at a single-digit multiple of normalized operating income; (3) the company's ability to generate positive adjusted operating income in Q2; and (4) leading market share and recognized brands in the growing market for removable storage.

Our Estimate of Fair Value

We estimate Imation's equity value at $480-751 million, or $13-20 per share. Our valuation approach is summarized in the following table.

Source: Company filings, Manual of Ideas analysis.

Imation Q&A

Q: What is your main concern regarding Imation?

A: Our key concern is that equity value may not be maximized in a timely manner, despite the fact that insiders do not have voting control. Imation's strong balance sheet, brand recognition and large installed base could make it an attractive acquisition target, but the staggered Board of Directors and "golden parachute" arrangements with top executives could keep away potential acquirers. With the CEO owning less than 1% of the stock, management may not view shareholder value creation as urgently as might be expected given the current depressed valuation.

Q: What is Imation's relationship with TDK?

A: TDK, one of Japan's largest recording media and device companies, owns 21% of Imation. In 2007, Imation bought TDK's removable recording media business for $41 million, acquiring the exclusive right to use the TDK Life on Record brand through at least 2032. TDK also has a representative on Imation's Board of Directors.

Q: What is your view of the Philips litigation settlement?

A: Obviously, the settlement will take a chunk out of Imation's cash balance over the next three years. Note that we have already adjusted for this in our calculation of enterprise value; in fact, our adjustment is conservative because we assume no tax benefit related to the settlement expense. Ultimately, the settlement should be positive for Imation, as it removes an estimated $4-6 million of quarterly litigation-related expense. This should make the company's underlying profitability more readily apparent, perhaps providing a catalyst for Imation shares.

Catalyst

- Removal of litigation-related expenses and restructuring charges, making company's normalized earning power more apparent to investors.

- Potential activist involvement or strategic action to unlock value, as company has strong, liquid balance sheet and is not controlled by insiders.