Description

I believe that Imagistics International is forecasting earnings well below levels they will achieve in the near future. Over the medium term future, as EPS converges with FCF, IGI has the potential for significant price appreciation. Imagistics International (IGI) is a compelling long opportunity with strong free cash flow yield, with explosive margin expansion on the horizon, that is buying back shares, that is paying off what little debt it has, that has a strong management team, and is completely undiscovered by Wall Street.

KEY FACTS:
Imagistics was spun out of Pitney Bowes (“PB”) in December 2001 and has no Wall Street coverage. FCF excluding WC improvements in 2002 was $44 million. Including WC improvements it was $92 million, yielding 24% on enterprise value. IGI used that cash to pay down $43 million of debt and buyback 1.9 million shares of stock for $37 million while still increasing its cash balance by $12 million. 2002 revenue was essentially flat at $630 million and 75% is recurring. The market appears to be valuing IGI off of its EPS, which is artificially depressed from an aggressive depreciation schedule, the tail end of an expensive IT installation, an inventory obsolescence charge (as the company shifts from analog to digital imaging machines), and the development of a large centralized distribution center, rather than its current and future cash flow generation capabilities.

COMPANY OVERVIEW:
Imagistics rents, sells, and services document imaging machines directly to a broad corporate and government customer base. Document imaging machines include copier/printers, fax machines, and multifunctional products (MFPs) that combine copiers, faxes, scanners, and printers into one machine. Stand-alone networked printers are an untapped but natural market for IGI to eventually enter. IGI rents and sells “best of breed” private label products. IGI has many vendor relationships and focuses only on supplying products that have passed its rigorous testing standards. IGI does not seek the cheapest imaging machine in each class, it seeks the highest quality. IGI has an installed base of over 300,000 copier/printers and fax machines. It recently began focusing its sales efforts on Fortune 1000 customers; trying to both acquire new customers and push deeper into its current customers. It launched a national brand awareness marketing campaign in 2002.

Other key business characteristics:
- management is forecasting EPS growth of 20% for 2003, 2004, “and beyond.” I believe it will grow faster than this
- traditional installed base of fax machines customers are being upsold copiers and MFPs
- industry-wide shift from analog to digital products
- high margin faxes are being bundled into other products (MFPs) that have lower margins but higher sales per unit
- low margin legacy contracts from IGI’s Pitney Bowes days continue to be replaced with higher margin contracts over the next two to three years
- IGI is also in the midst of a several year project to establish a new “mega-distribution center” in Columbus, Ohio. They expect this will improve distribution, inventory, and other supply chain related costs
- Management is currently spending to train its sales force to cross sell. Historically, certain people sold fax machines and others sold copiers, in the future each sales person will sell both
- 75% of 2002 is recurring revenue (13% from support services, 37% from rentals, and 25% from supply sales). The other 25% is equipment sales
It should be noted that Imagistics’s management has historically been prudent and conservative in its spending. Additionally, they have raised earnings expectations three times in their first fourteen months of independent operations. I trust their judgment in spending on the large projects they are currently working on.

ACQUISITIONS:
Imagistics has made several small acquisitions in the past. Unlike some of its competitors that are rollups (IKON, Danka, and Global Imaging), IGI has focused its acquisitions on small companies in secondary markets. It will continue to evaluate that alternative going forward. Today, in areas where Imagistics is underrepresented it outsources some of its servicing business to Pitney Bowes. Future acquisitions will focus on building out IGI’s service and distribution footprint. IGI also may use acquisitions as a way to continue expanding into the UK.

FCF and EPS EXPANSION:
Before getting deep into the financials, I should clarify why I believe EPS and FCF are significantly depressed. For a glimpse at IGI’s future, first take a glimpse at its past: I highly recommend you look at its Form 10 filed on Nov. 6, 2001 just prior to going public. EPS and cash flow per share in that filing are close to where I think they’re going. There have been a few major cash and book costs incurred in each of the last two years that I believe are out of whack with where they normally should and will be:

1) D&A Temporarily above CapEx - Imaging machines are aggressively depreciated to zero on a straight line basis (i.e. their useful life is significantly longer than their depreciation schedule). Copiers and MFPs are depreciated on a straight line in three years and faxes in five years. Copier and MFP procurement costs have significantly improved as the economy has worsened. This has created a situation where D&A off of old machines is well above maintenance CapEx and actual CapEx. As D&A declines relative to revenue over time, EPS will increase;

2) Non-cash Inventory Obsolescence Charge - As IGI’s business has shifted from analog machines to digital, IGI has aggressively written down most of its analog inventory ($15 million in 2002 and $21 million in 2001). These are large non-cash charges that go through COGS. Management does not split these charges out as line items on the income statement or discuss them in depth, so without working backwards from the CF statement and talking to management, the average investor may miss them. At this point, most of the analog inventory has been written off. Write offs of this magnitude are not expected to occur going forward, though some small obsolescence will naturally occur (I assume $2 million per year);

3) IT Upgrade – To become completely autonomous from PB, an ERP system is being installed with a cash cost of $20+ million per year and an accounting expense of $8+ million per year (the difference is capitalized). At the same time, IGI pays PB $5-$6 million per year for use of its legacy IT system. When installation of the new ERP is completed in 2004, the accounting expense will continue to be approximately $7-$8 million per year, but the annual cash cost of IT, including PB savings, will be $20 million less than it was in 2002 (pure FCF expansion). Additionally, SSA as a % of revenue should gradually decline from added efficiency; and
4) Mega-Center Buildout – Imagistics is building a large distribution center in Columbus, OH. This several year project is expected to create significant savings and nearly double inventory turns. I have not projected any savings from this, but the reader should be aware that this will have significant value to IGI.

COMPETITION and GROWTH:
In 2002, Imagistics revenue was essentially flat at $629.9 million (up 1% from 2001) during a year when the industry struggled. 75% is recurring revenue (13% from support services, 37% from rentals, and 25% from supply sales). The other 25% is equipment sales. Xerox, the industry bellwether, had sales and service revenue decline by 5% a year for each of the last several years. The business machines segment’s sales growth of another large competitor, Canon, has been rather flat. IKON, another multi-vendor private label document imaging machine company, has seen its sales and service revenue decline by 3% and 9% the last two years. Of these three competitors, Canon has the most bullish business outlook for its copier segment, though that strength is in low-end copiers. In the face of these industry struggles, Imagistics slow growth is strong performance. It has actually grown its copier and MFP business, while its fax business is expected to continue deteriorating. Additionally, IGI believes its normalized top line growth rate is probably closer to 8%. However, revenue growth is not necessary for IGI to be a compelling valuation at these levels.

CASH FLOW GENERATION:
The company aggressively depreciates its rental assets. While this depresses paper profits today, it is creating a very bright future for EPS growth. Today, all copiers and MFPs are depreciated on a straight line in three years and faxes in five years. The interesting thing is that these machines have much longer useful lives than that. The associated rental contract may end when the asset is fully depreciated, but IGI is more than happy to re-rent them or refurbish the machines and sell them at extremely attractive gross margins (100% minus the cost of refurbishment). I am not assuming any reduction in D&A in the short term due to the ERP and mega-center projects.

Part of SSA expense is an annual $5 million payment to Pitney Bowes for use of its legacy IT systems. Imagistics is installing a new ERP system over approximately three years costing nearly $60 million that will replace the PB system. There is about one year remaining for the installation and $35 million has already been spent ($21 million in 2002, $14 million in 2001). On a cash basis, it will cost $6 - $7 million a quarter until completion (a portion of which is training). When completed, the ERP system will eliminate the $5 million annual payment to Pitney Bowes. The ERP system will improve customer service, support, and tracking, reduce SSA expenses, and provide working capital improvement opportunities. I’m assuming annual cash ERP maintenance costs will be approximately $5 million per year. Management expects the ERP system to be completed by approximately year-end. In order to allow for delays, I’ve assumed it continues for six more quarters. FCF will improve by about $20 million per year (a 5% yield on enterprise value) just by completing ERP installation. My forecast assumes flat FCF for 2003, but $12 million of FCF improvements from reduced ERP spending in 2004 ($20+ million/year after that).

One new SSA cost that won’t go away is marketing and advertising. IGI used to benefit from PB’s marketing effort but must now do so itself. It was $10 million last year and I am assuming it continues at that level this year.

Unlike most companies, cost cutting means more to IGI than just layoffs. Because IGI is not tied to any one machine manufacturer (vendor) and buys direct, it serves as the incremental buyer in an industry plagued by overcapacity. Manufacturers compete for IGI’s business. This has allowed IGI to get improved pricing on the machines it buys. These improvements are reflected in the expanding gross margin and the growing discrepancy between D&A and CapEx..

Over the last two years, Imagistics has vastly improved its working capital situation. In 2002, working capital improved by $38 million ($53 million less $15 million for obsolescence of inventory). IGI is not forecasting any additional WC improvements going forward. As the ERP system and mega-center come online, inventory management and customer service will continue to improve. I have assumed no additional change in WC (I have also assumed zero sales growth).

Base line 2002 FCF calculated as EBIT * [1-40% tax rate] + D&A – CapEx was about $44 million ([$35.4 EBIT + $15.1 one time obsolescence – $2 annual obsolescence] * .60 taxes + 81.6 D&A – 66.6 CapEx). I am assuming no improvement or growth in sustainable FCF in 2003 though management, who is rather conservative, forecasts a $52-$60 mm of FCF in 2003 (no WC improvements are assumed). Whether you use my estimate or management’s, we’re talking about 2003 FCF yields between 11% and 15% on enterprise value. Remember, in 2004 the ERP system will be in place and that will add about $5-$6 million of FCF per QUARTER (I added six months of buffer, so my 2004 estimate only includes two quarters of the ERP system being complete), resulting in additional annual FCF yield of about 5% per year. These estimates do not account for any cost improvements associated with using the ERP system or any cost improvements associated with the mega-center being developed in Ohio.

CASH MANAGEMENT:
In 2002, Imagistics used its sustainable FCF and WC improvements to pay down $42.9 million of debt (1/3 of its outstanding debt), buyback 1.9 million common shares for $36.5 million (approximately 10% of outstanding equity), and increase its cash on hand by 67% (an additional $12.5 million). As FCF grows and debt continues to decline, IGI can be expected to continue aggressively buying back shares*. IGI is currently authorized to buyback $21 million more of shares out of an original $58 million plan. I am assuming that in 2003 IGI buys back $20 million worth of equity at an average price of $20/share or 1.0 million shares and pays down $20 million of debt. In 2004, I am assuming additional share repurchases are approved and that IGI buys back $30 million worth of equity at an average price of $22/share or 1.36 million shares and will pay down another $25 million of debt.

Revenue:
2002A: $316.3 million
2003E: $316.3 million
2004E: $316.3 million

EBIT:
2002A: $35.4 million
2003E: $48.4 million (assumes $2 million of inventory obsolescence per year)
2004E: $51.1 million (excludes potential ERP and mega-center savings and includes half a year of PB’s legacy ERP system of $2.7 million)

FCF:
2002A: $44 million
2003E: $44 million
2004E: $58 million

Net Interest Expense:
2002A: $8.1 million
2003E: $4 million
2004E: $1 million

Tax Rate: 40%

Net Income:
2002A: $16.4 million
2003E: $26.6 million
2004E: $30.1 million

FD EPS:
2002A: $0.86
2003E: $1.49 (if no shares are bought back: $1.45)
2004E: $1.80 (if no shares are bought back again: $1.64)

Key Balance Sheet Items 12/31/02:
Cash: $31 million
Total Debt: $74 million
Book Value: $264 million

VALUATION:
My estimates assume no revenue growth and no margin expansion other than the conclusion of two large recent, short term costs: inventory obsolescence and ERP installation completion:
- 10x sustainable FCF: $24.61 per share based on 2003 FCF per share, $34.73 per share based on 2004 FCF per share
- 10x management’s FCF estimate: $31.31 per share based on 2003 FCF of $56 million (midpoint of $52-$60 range, provided by management). Management has not provided a 2004 estimate, but they have said they expect the ERP project to be completed much earlier than my estimates provide for, thus adding about $20 million of sustainable FCF improvements (more than $10/share of value)
- Assuming no multiple contraction (currently trades at 18x management’s $1.05 forecast): $27 per share based on 2003 EPS of $1.49, $32 per share based on 2004 EPS of $1.80

RISKS:
Each risk should be considered in the context that management has been very conservative so far and has proven to be a shareholder friendly allocator of capital. I think downside business performance is limited:
- Significant undisclosed or increased costs (e.g. significant continued high levels of inventory obsolescence)
- The business deteriorates overall. This is mitigated by the recurring nature of the revenue
- The ERP system is more expensive than previously thought (my FCF estimate already includes $12 million of buffer)

* In a public company’s first two years it can buyback no more than 20% of its shares outstanding.

Catalyst

CATALYSTS/UPSIDE:
- Imagistics hits management’s FCF forecasts of $52-$60 million (vs. my estimate of $44 million). Management has historically come in above its initial forecast
- Margin expansion. Every million saved is $0.03 EPS. Management predicts that the ERP and mega-center will help improve SSA significantly. I’ve assumed no associated improvement
- Imagistics’s announces EPS well above its current forecasts
- The ERP system is completed on time and on budget, thus adding an additional $12-$15 million of FCF to my 2004 estimate
- Other significant cash costs conclude. In particular, the completion of the mega-warehouse will lower CapEx by a couple million per quarter
- The market recognizes IGI’s improved balance sheet and strong FCF, bringing the FCF yields to a more appropriate level
- Revenue growth. Management sees normalized top line growth of around 8%, though I’ve forecast none…ever