MATTHEWS INTL CORP -CL A MATW S
July 23, 2018 - 2:21pm EST by
Woodrow
2018 2019
Price: 58.00 EPS 3.79 3.80
Shares Out. (in M): 32 P/E 15.3 15.3
Market Cap (in $M): 1,864 P/FCF 16.1 16.1
Net Debt (in $M): 982 EBIT 163 178
TEV ($): 2,846 TEV/EBIT 17.5 16.0
Borrow Cost: General Collateral

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Description

Short – Matthews International (MATW)

 

Matthews International (MATW) is an acquisition roll-up short which has used a number of financial shenanigans to disguise its weak operational performance.  MATW is an industrial conglomerate operating with businesses spanning the memorialization segment (caskets, grave stones, and bronze funeral memorials), the printing and advertising space for consumer-packaged goods (“CPG”) companies and retailers, and the warehouse fulfillment system and printing space.  While MATW’s business mix is relatively diverse, one commonality is that the majority of its business units have demonstrated flat to negative organic growth trends.

 

We believe that over the past five years, MATW has attempted to mask its weak organic growth with a string of debt-financed acquisitions that have artificially boosted the Company’s reported growth in revenue and EPS but have destroyed material shareholder value.  These acquisitions have not helped Matthews diversify into healthier and higher growth businesses but have instead doubled down on the same challenged segments. The Company has further obfuscated its weak operating performance by presenting investors with adjusted EPS and EBITDA metrics that exclude large cash acquisition integration and productivity charges.  We question the propriety of these charges since they have remained stubbornly high for the past four years but have not resulted in material synergies or operating margin improvement. Finally, MATW provides weak disclosures that serve to confuse investors and make the Company’s superficial financial metrics seem much better than they really are.

 

It is unclear whether MATW’s core business is in a steep secular decline or whether its acquisitions and integration charges have yielded extremely poor financial returns.  However, either scenario should ultimately result in substantial share price degradation. We believe that MATW is running out of levers to pull to continue representing an unrealistically favorable view of its financial results and, over the coming year, we expect that investors will gain a clear understanding of the challenges facing the business.  The Company’s high debt levels should limit its acquisitiveness going forward and the SEC appears to be taking notice of the Company’s aggressive accounting policies.

 

On February 20, 2018, the SEC wrote a letter reviewing the Company’s filings, which raised several important questions about the adequacy and propriety of the Company’s financial disclosures.  We believe this SEC correspondence highlights many of the key issues that underpin our short thesis on MATW. These comments can be boiled down to the following arguments: 1) the Company does not disclose its organic growth or the factors underlying its revenue growth (or lack thereof); 2) MATW has been adjusting its results for high level acquisition-related “one-time” charges, but has not provided information around the nature of these costs or the benefits they are expected to yield; and 3) MATW has provided poor disclosures around the sustainability of other items that have artificially boosted its EPS growth like its unusually low tax rate and unconventional EPS add-backs.

 

We cannot be sure that the SEC comments will lead to an investigation or a larger restatement of the Company’s financials, which would clearly benefit our short position.  However, regardless of the SEC’s course of action, we believe that MATW will have increasing difficulty meeting analyst estimates due to the secular pressures on its businesses.  MATW’s management should be on notice that regulators are taking a closer look at its aggressive accounting practices and thus may take a more cautious approach on non-GAAP earnings adjustments and other tactics that have artificially boosted recent results.

 

We believe that the market should become aware of Matthews’ deceptive tactics over the coming quarters as the Company’s financial performance deteriorates.  We expect MATW’s fiscal year ending September (“FY”) 2019 adjusted EPS to come in at $3.80 or worse, well below current market consensus expectations of $4.30.  When one includes accounting costs that MATW excludes, but its peers do not, this translates to actual EPS of $2.90. Using comparable multiples of small- and mid-capitalization memorialization, print marketing, and industrial companies and our below consensus numbers, we arrive at a price target of $31.52 to $36.92, representing between 39% and 48% downside for the shares.

 

Company Description

 

Matthews International operates in three reporting segments: Memorialization (40% of last-twelve-months (“LTM”) sales); SGK Brand Solutions (51% of LTM sales) and Industrial Technologies (9% of LTM sales).  The memorialization segment sells caskets to funeral homes, bronze and granite memorials to cemeteries and cremation equipment and services. The SGK brand solutions segment provides printing support and creative design to retailers and CPG customers to assist with product packaging and merchandising displays.  This segment also provides tooling, such as cylinders and plates for printers, to assist its CPG and retailer customer base. Lastly, the industrial technology segment provides inkjet, thermal and laser marking products and warehouse fulfillment systems to industrial and warehouse customers to assist in sorting and tracking products.

 

Prior to its recent acquisition binge, MATW was a company with low financial leverage, stable cash flows and slow organic growth.  At the beginning of FY 2013, MATW’s debt-to-LTM EBITDA was 2.0x, and had been around those levels for several years. However, starting in FY 2014, MATW began an aggressive acquisition program that has dramatically increased its financial leverage.  The biggest acquisitions were Schawk (SGK) in FY 2014, a printing and marketing business for CPG companies and retailers, and Aurora Casket Company (“Aurora”) in FY 2015, the third largest burial casket manufacturer. However, the Company has supplemented these larger acquisitions with a string of smaller deals.  Over this period, MATW has spent a little over $1.3 billion on acquisitions and related integration costs, taking its leverage up to 4.1x net debt-to-adjusted EBITDA. Thus far, investors have applauded MATW’s strategy with its shares returning 52%, compared to a 43% return for the Russell 2000, since the day before the Schawk deal on March 17, 2014.  However, with the pace of acquisitions slowing, we believe that future share price performance will be much worse.

 

Poor Execution on Acquisition Roll-Up Strategy

 

While MATW’s acquisition binge has clearly benefited revenue and EPS due to a low-cost debt environment, we believe that the Company has destroyed substantial shareholder value.  We do not know whether the value has been destroyed by poor acquisition performance or declines in the core business, but either scenario should result in material share price declines.

 

Since the beginning of FY 2013, MATW has made net acquisitions and investments totaling just under $1.2 billion and taken restructuring and strategic charges of $177 million for a total spend of over $1.3 billion.  Meanwhile, from FY 2013 to FY 2018, adjusted EBITDA is expected to have increased by a mere $94 million based on analyst estimates (which we believe are aggressive). This implies that MATW has essentially paid 14.1x for the additional EBITDA it has created over this period, assuming that EBITDA in the core business has not grown over the past five years.  However, most companies that trade at MATW’s multiple would have been expected to have generated at least a 5.0% organic EBITDA CAGR over the past five years of economic expansion. If we assume that scenario, it implies that MATW paid a ridiculous 26.6x EBITDA for its acquisitions and related synergies.

 

Moreover, since MATW focuses investors on its free cash flow generation, we should consider EBITDA minus additional capital expenditures from acquired companies as well.  On this score, capital expenditures over the last-twelve-months are $29 million higher than they were in FY 2013. This means that MATW has paid approximately 20.3x EBITDA minus capital expenditures for its acquisitions over this period, if we assume stagnant growth in the core business.  Even with the current low tax environment, this equates to a dismal 3.7% after-tax return on the capital MATW has invested in this period. This rate of return is well below the Company’s cost of capital and even below the cost of debt on the Company’s recently issued bonds. Therefore, we believe that either the core business is performing extremely poorly or the Company is destroying value with its active acquisition strategy.

MATW’s track record of adding value to companies it acquires also appears poor.  MATW has only detailed the revenue contribution from its largest two acquisitions, Schawk and Aurora, but the Company’s performance in both deals was not encouraging.  In the case of Schawk, it appears that the Company’s revenue declined by 6.5% in its first year of MATW’s ownership. Meanwhile, Aurora declined by a shocking 10.0% in the first year of MATW’s stewardship.  Nevertheless, in that timeframe, the stock appreciated by 53%.

 

In summary, it is hard to argue that MATW has added value from its acquisition program unless you believe that declines in the core business are much worse than they appear.  If this is the case, these pressures will be more problematic for Matthews with the higher leverage incurred as part of these deals. Additionally, we believe the Company’s EBITDA contribution is even lower than it appears and that MATW has been overly aggressive in recognizing acquisition integration charges.

 

Matthews Faces Secular Pressures that Have Resulted in Organic Revenue Declines

 

We believe that MATW faces significant secular pressures in its core business lines that should lead to disappointing revenue growth once the pace of its acquisitions slows.  The memorialization segment faces secular growth headwinds as increases in the number of people choosing cremation over traditional burial should cause volume declines for the foreseeable future.  Furthermore, consumers have shown a tendency to choose cheaper caskets and memorials in recent years. These trends have caused competitor Hillenbrand (HI) to guide the market to -1.0% to -3.0% revenue growth in its casket segment for the foreseeable future.  Moreover, HI believes that it needs to pursue an aggressive restructuring program to even maintain margins at current levels.

 

Meanwhile, SGK Brand Solutions continues to be pressured by weak spending from large CPG companies, faced with competition from smaller brands, private label and internet retailers.  These issues have been exacerbated by the digitalization of printing and pressure on print advertising budgets as more dollars flow online. MATW continues to call for a snap-back in growth in this segment referencing large customer wins in the private label space.  However, we believe that these wins will be largely offset by attrition elsewhere as MATW’s client base is clearly struggling. Finally, while the industrial technology group should be able to grow faster than the other two segments, it is small and has also produced weak levels of organic growth over the past several years.  This suggests that the Company’s product portfolio is poorly positioned. The Company hopes to re-invigorate its growth in this segment with a new printer that can print on non-paper substrates. However, even if this product is an overwhelming success, it will be hard for it to move the needle in light of the weak growth in the other segments.

 

To date, MATW has been able to mask its weak organic growth with acquisitions.  However, unlike the majority of public companies, MATW does not detail the impact of acquisitions on its growth rates.  This practice has caught the attention of the SEC. In the SEC letter to MATW, they clearly state that the Company should “[q]uantify the impact acquisitions had on revenues, gross profit and operating profit for all periods presented.”  In response, MATW argues “the impact of acquisitions on the Company’s financial results cannot always be determined with precision due to the nature of our businesses and the integration of these newly-acquired companies into our core operations.”  This is a deceptive response to the inquiry because, as MATW readily admits, if the Company chose to do so, it could easily quantify the historical sales of the acquired operations and present a pro forma growth disclosure. Moreover, for charges related to acquisitions, Matthews seems to have no problem differentiating “one-time” expenses from ongoing operating costs.  We believe that the Company intentionally chooses not to provide this information because its growth has been so poor.

 

Due to the secular headwinds facing MATW’s business, the Company’s sales appear to have declined organically over the last several years despite a strong economic backdrop.  In order to solve for organic growth, we have scoured the Company’s disclosures on the revenue run-rates of recent acquisitions and made assumptions on acquisition price-to-sales multiples where historical revenue is not disclosed.  Based on our analysis, the Company’s organic revenue has shrunk at a -1.8% CAGR when adjusted for currency and acquisitions over the last two years. This has been driven by -3.1% organic growth for SGK Brand Solutions, -0.4% growth in Memorialization, and -0.3% growth for Industrial Technologies.  More recently, trends do not appear to have improved in the first half of fiscal 2018, with organic growth further slowing to -2.4% despite accelerating macroeconomic trends in most other sectors.

 

While few investors are willing to do the work to solve for MATW’s organic growth at this point in time, the Company’s poor rate of growth should become apparent in the near future.  MATW is currently well above the high end of its leverage targets and should not be able to make as many acquisitions on a go-forward basis as it focuses on deleveraging. Furthermore, over the past year, currency has been a substantial tailwind to top line growth.  However, if currencies remain where they are, it will become a headwind to growth in the coming quarters. In FY 2018, we estimate that currencies will add approximately 2.0% to MATW’s reported revenue growth, but at current rates they should detract around 0.6% in 2019.  Similarly, acquisitions are likely to add 6.0% to MATW’s growth in 2018, but with the acquisitions consummated thus far we estimate the benefit will be only 1.3% in 2019.

 

Finally, several of MATW’s businesses have large orders that can substantially impact the Company’s growth rate in a given quarter, but MATW often fails to mention the benefit it received from these orders.  Based on our due diligence, one such order was a large in-store display contract for a global electronics company that benefitted last year’s June quarter revenues in its SGK brand solutions business by approximately $15 million or 7.5% of revenue.  This order received no mention in the Company’s earnings call that quarter but will likely be discussed if the Company posts weak results in that segment in the current quarter. Since MATW has been highlighting large customer wins in this business, many investors are optimistic about its growth potential in the coming quarters.  Therefore, we believe that these investors may be disappointed with MATW’s growth in that segment in the June quarter as this slow growth business anniversaries such a large order that had not previously been openly disclosed.

 

In conclusion, we see little evidence that MATW can demonstrate the organic revenue growth rates to hit analyst targets if it slows down its accelerated pace of acquisitions in order to reduce debt.  Therefore, the Company will need to significantly increase its margins to grow earnings in the future. However, we believe that the outlook for future margin expansion is equally bleak.

 

High Level of Questionable Charges Appear to Have Overstated MATW’s Earnings

        

Since the acquisition of Schawk approximately four years ago, MATW’s earnings and EBITDA have been adjusted for large acquisition and integration charges despite the fact that MATW’s major acquisitions were consummated in fiscal years 2014 and 2015.  While it is a common practice to exclude acquisition integration and special items, MATW’s acquisition and integration charges have recurred for an unusually long period of time and remain persistently high. In the past four and a half years, adjusted earnings per share excluding acquisition and integration charges have been 34% higher than they would have been had MATW not excluded them.  Moreover, in the last twelve months, adjusted earnings per share are still 26% higher without charges even though we are now well beyond a typical acquisition integration period.

 

SEC Questions Propriety of MATW Non-GAAP Disclosures

The SEC has noticed this issue and raises two relevant questions.  First, the SEC asked “[w]e note that you adjust for acquisition-related items in arriving at your various Non GAAP measures.  Please tell us and expand your disclosure to address the underlying nature and material cost components of this adjustment. Please explain how you concluded that these expenses are not normal, recurring, cash operating expenses necessary to operate your business.”  To answer this question, MATW suggested that it had told investors that acquisition integration costs would “continue for an extended period of time” due to “the significant size and projected synergy benefits from integration.” While MATW defended its definition of acquisition costs, the Company did reassure regulators that “acquisition-related items declined significantly in the fiscal 2018 first quarter compared to the prior period reflecting that the integration efforts for the acquisitions are nearing completion.”  Perhaps coincidentally, FY Q1 2018 was a very weak quarter with adjusted EBITDA declining by 8.2% despite substantial benefits from newly acquired businesses and currency. Moreover, in FY Q2 2018, acquisition costs and special items returned to their previous levels and actually increased by 4.6% on a pretax basis. Interestingly, this quarter demonstrated a much improved 7.1% growth in adjusted EBITDA.

 

Second, MATW should be earning some financial return on all of these one-time integration and productivity initiative charges since they are essentially capital investments to achieve substantial future synergies.  On this score, the SEC asked MATW to “[q]uantify the benefits of productivity initiatives and realization of acquisition related synergies.” Unfortunately, these charges appear to have yielded little in the way of financial benefits.  The SGK brand solutions business has been the beneficiary of the majority of this spending and its LTM adjusted EBITDA margins are exactly in line with 2015 levels at 13.3%. Similarly, the memorialization segment has improved its margins by a mere 60 basis points since 2015, a level of margin improvement that most companies would typically attribute to continuous improvement initiatives.  Therefore, we believe that either the businesses are experiencing significant pressure on their margins and synergies are helping to hide these issues, or these charges are not as “one-time” as MATW would have investors believe.

 

Taken as a whole, we believe MATW’s disclosures around its acquisition strategy are logically inconsistent.  In MATW’s responses to the SEC’s questions on organic growth, management claimed that the majority of its acquisitions are integrated so seamlessly that it cannot tell the difference between organic growth and acquisition-related growth.  However, the Company appears to have no difficulty distinguishing between “one-time” costs related to acquisition integration and everyday costs of running its business. Moreover, in fiscal 2015, MATW was forced to disclose weaknesses in internal controls due to a $15 million theft of Company funds by a long-time employee.  If MATW’s accounting systems are not precise enough to catch $15 million of cash going out the door, we are skeptical that they can precisely separate on-going and one-time expenses. If we are correct that some of MATW’s acquisition related costs are really recurring costs, margins should come under pressure from reduced charges going forward, assuming the Company indeed fulfills its commitments to investors and the SEC.  In fiscal 2019, MATW has committed to reduce its charges by approximately $13 million, representing a $0.29 headwind to EPS.

 

MATW’s Creditors Have a Divergent View on Acquisition Integration Charges and Timing

The SEC letter has an interesting section about the sparse information that MATW provides about its debt covenants, which highlights the egregious nature of MATW’s acquisition-related charges.  SEC investigators asked MATW for the following information: “Your disclosures should include actual ratios/amounts for each period and the most restrictive required ratios/amounts. Please show the specific computations used to arrive at the actual ratios with corresponding reconciliations to US GAAP amounts.”  While we do not know why the SEC asked for improved disclosure around MATW’s covenants, we believe that this question has significant implications.

 

In many cases, companies that make substantial non-GAAP adjustments to their financial results justify their adjusted EBITDA by stating that it matches a similar metric in the credit agreement.  We believe that this is interesting because a careful read of MATW’s credit agreement shows that lenders do not have as permissive a view of charges as the adjusted EBITDA and EPS that MATW presents to investors.  According to MATW’s credit agreement, the Company may only exclude acquisition integration expenses to the extent that they occur within 18 months of a permitted acquisition. However, for adjusted EBITDA and EPS purposes, MATW still claims to be taking charges to integrate the Schawk acquisition which closed in July of 2014.  In our experience, 18 months is a much more typical integration period than the five years that the Company tells its investors that acquisition integration costs can persist.

 

Other Financial Shenanigans

 

MATW also uses several other accounting gimmicks that have benefitted recent period earnings but will likely become headwinds in future periods.  We believe that investors have not seen through these practices because MATW’s disclosures are so poor and confusing.

 

Low Tax Rate Benefitted FY 2017 and FY 2018 and Will Pose a Significant Headwind to FY 2019

One such item that has substantially benefitted earnings in recent periods is an extraordinarily low tax rate used to calculate adjusted EPS.  In FY 2017, which did not benefit from the new tax law, MATW saw its adjusted tax rate decline from 31.0% in FY 2016 to 23.5% in FY 2017. This allowed MATW to report a healthy 6.5% increase in adjusted EPS, but if the tax rate had remained constant, EPS would have declined by approximately 4.0%.  Similarly, in fiscal Q1 2018, MATW’s tax rate declined to a mere 10.5% despite the fact that the Company had yet to benefit from 2018 tax reform. This reduced tax rate allowed the Company to show a 3.3% decline in EPS versus a 24.4% decline had tax rate remained at the expected 30.0% level. This low tax rate was the difference between MATW beating consensus EPS expectations by $0.03 and missing by $0.11.  

 

If the Company believes that it is creating value through strong tax planning, we believe that it should highlight the low tax rates it has been paying in recent periods.  Instead, the Company has made its disclosures around taxes and extraordinary items so confusing that few investors understand what the adjusted tax rate was in any given period.  MATW does not clearly reconcile its non-GAAP earnings on a pre-tax and after-tax basis, so many investors are unaware of the unusually low tax rates that the Company is enjoying. To this point, one of the sell-side analysts who follows MATW simply hard codes for adjusted EPS and does not even bother reconciling GAAP and non-GAAP EPS in a more granular fashion.  The SEC appears to have noticed the impact of tax rates on MATW’s adjusted EPS and requested that MATW provide improved disclosures around the drivers of its extremely low tax rate. Furthermore, the SEC requested that MATW “disclose the tax effect of [its] non-GAAP adjustments as a separate reconciling item and address how the tax effect was calculated.”

 

We believe that MATW will face significant EPS headwinds from its tax rate in FY 2019 versus FY 2018.  The Company has guided investors to a normalized tax rate of approximately 26.0% under the new US tax policy, but we estimate that MATW’s FY 2018 tax rate may be around 21.5%.  Since the Company’s fiscal year ends in September 2018, MATW only benefited from tax reform for three of its four quarters. Therefore, some investors may be expecting MATW to benefit from lower taxes in 2019.  However, if MATW’s tax rate reverts to 26.0%, this suggests that the Company would need to grow its pre-tax income by 16%, in order to achieve consensus EPS growth of 9%. Moreover, given a recent bond issue and increased rates on MATW’s floating rate debt, the Company should face $0.10 of additional EPS headwinds in fiscal 2019, meaning that adjusted operating profit will have to grow by around 19.0% to meet analyst EPS expectations.  Based on these headwinds, we believe that it will be difficult for MATW to grow its earnings at all in fiscal 2019, and that it will actually earn $3.80, compared to street expectations of $4.30.

 

Other Non-Traditional EPS Add-Backs Overstate MATW’s Earnings Relative to Comparable Companies

MATW is extremely aggressive in other add backs to net income that it uses to derive its adjusted EPS.  While some companies exclude acquisition-related amortization of intangible assets from their adjusted EPS, these companies do not refer to this metric as adjusted EPS.  Instead, they typically call their earnings “Cash EPS.” Moreover, many acquisitive companies that are used as valuation comparables for MATW, do not exclude this item from EPS, making MATW more expensive than it looks on the surface.  MATW also excludes all pension expenses other than the service cost component from both adjusted EPS and EBITDA because the Company claims that this is the truest measure of pension costs. This practice is extremely unusual and we are hard pressed to find another company who reports adjusted EBITDA or EPS in this fashion.  In total, these two exclusions have inflated MATW’s reported EPS by 27% even if one accepts all other charges in adjusted EPS as legitimate.

Therefore, MATW’s P/E ratio of 15.2x analyst estimates for 2018 may seem reasonable on the surface, but in fact it actually trades at a much higher 19.4x P/E multiple on an apples-to-apples basis.  For the purposes of our analysis, we have evaluated MATW’s valuation relative to its peers using EPS estimates that are calculated in a comparable way. After all, MATW already benefits from much larger exclusions of “one-time” charges than its comparables.  MATW also has substantially more debt than its peers, further enhancing its reported EPS. When we adjust our fiscal 2019 estimate of $3.90 in EPS for these non-traditional add-backs, we arrive at an apples-to-apples EPS estimate of $2.90.

 

Finally, in the past, MATW has been benefitting by making acquisitions and funding them with very low-rate borrowings on its credit facility, thereby making almost any acquisition immediately accretive.  However, if the Company honors its commitment to de-lever, it will earn a low 2.0% after-tax return on any capital it deploys to pay down debt rather than make acquisitions. To illustrate, if the Company spends $100 million to make a debt-funded acquisition at 8.0x adjusted EBIT, it creates $0.23, or around 6.0%, of EPS accretion.  If MATW uses that same $100 million to pay down debt, the EPS accretion is a mere $0.06, or around 1.6%. Since MATW is far more levered than the majority of its peers, this should further pressure its relative EPS growth going forward.

 

Memorialization To Face Significant Operational Headwinds in the Coming Quarter

 

In addition to the questionable accounting, we expect MATW to face substantial margin headwinds in its memorialization segment over the coming year.  First, the memorialization segment has benefited from higher than average death rates over the last year partially driven by a more virulent flu season.  This usually reverts to the mean the following year causing volume headwinds to the business. Even modest volume declines can pressure margins as this business is vertically integrated and has high fixed costs.  MATW has large manufacturing facilities and delivers products to its customers on fixed routes with its own internal distribution operation. As volumes slow, this should result in an increase in per-unit manufacturing and distribution costs.  Moreover, this segment should face cost headwinds with dramatic increases in steel, wood, bronze, and fuel costs. Since MATW pre-buys many of its raw materials, it has yet to be impacted by these raw material shocks but should face pressure in the coming quarters.  Historically, it has been difficult to pass these price increases on to consumers. While MATW may increase prices to funeral homes and cemeteries, this usually results in mix downs where consumers buy cheaper, lower-margin caskets and memorials, nullifying the benefits of pricing.

 

In fiscal 2012, a year where MATW saw rising commodity input costs and lower casketed burials, the Company saw substantial declines in adjusted operating profits on modest sales decreases.  In this period, sales declined by a mere 2.9% (although MATW made a modest acquisition, so the organic decline was slightly higher). However, adjusted operating margin declined by 240 basis points resulting in a 17% decline in adjusted operating profits.  We believe that 2019 will present a similarly difficult situation as MATW copes with a tougher comparable in terms of death rates and faces an inflationary cost environment. However, analysts are looking for margin expansion in this segment next year.

 

In summary, analysts are expecting a little over 100 basis points of EBITDA margin expansion from MATW in fiscal 2019 versus 2018.  We believe that this target will be extremely difficult to achieve while the Company is facing headwinds in its memorialization segment and reducing acquisition related charges.  Therefore, our EPS estimates for fiscal 2019 are well below consensus expectations.

 

Valuation and Conclusion

 

In summary, we believe that it will become increasingly difficult for MATW to meet consensus expectations for revenue and earnings growth in the coming quarters and year.  The Company has a poor track record of organic growth and has shown little ability to improve its margins despite spending aggressively on acquisition-integration and productivity initiatives and aggressively using accounting gimmicks to mask this lack of growth.  Thus, even if the SEC does not conduct a further investigation, we believe Company fundamentals will result in material downside to the shares.

 

On a go-forward basis, MATW will have a constrained ability to grow through acquisitions as investors are expecting the Company to meet its deleveraging commitments.  We believe that these acquisitions and related charges have hidden major secular growth and margin challenges in the Company’s core business lines. Moreover, in the coming year, the Company will face substantial headwinds from margin pressure in its memorialization segment, higher interest rates on its debt, higher tax rates, and less ability to exclude “one-time” charges from its adjusted results.

 

Due to its diverse and generally unrelated business segments, it is difficult to find a perfect comparable company peer group for MATW.  However, we looked at several peer companies that participate in similar printing, marketing, memorialization, and industrial business segments and found that peers are trading at 12.7x FY 2019 P/E and 7.7x FY 2019 EV/EBITDA, which seems fair for a company with Matthews’ limited growth prospects.  Based on these multiples we arrive at a price target of $31.52 to $36.92, representing between 39% and 48% downside for the shares.

 

Moreover, our estimates are based on a continuation of the current favorable macroeconomic climate.  In a weaker environment, MATW could see significant EBITDA declines and given its high financial leverage, may face covenant violations, resulting in substantially more downside risk for the shares.

 

Any forward-looking opinions, assumptions, assessments, or similar statements constitute only subjective views. This information should not be relied on for investment decisions and is subject to change due many factors, including fluctuating market conditions and economic factors.  Such Statements involve inherent risks, many of which cannot be predicted or quantified and are beyond our control. Future evidence and actual results could differ materially from those set forth in, contemplated by, or underlying these Statements, which are subject to change without notice.  In light of the foregoing, there can be no assurance and no representation is given that these Statements are now, or will prove to be, accurate or complete. We undertake no responsibility or obligation to revise or update such Statements.

I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise hold a material investment in the issuer's securities.

Catalyst

1) Q3 Earnings Report Should Show Weak Growth in SGK Brand Solutions

2) 2019 Guidance Should Show Limited EPS Growth

3) Deterioration in Performance in Next Several Qs 

4) Potential for Further Scrutiny by Regulators

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    Description

    Short – Matthews International (MATW)

     

    Matthews International (MATW) is an acquisition roll-up short which has used a number of financial shenanigans to disguise its weak operational performance.  MATW is an industrial conglomerate operating with businesses spanning the memorialization segment (caskets, grave stones, and bronze funeral memorials), the printing and advertising space for consumer-packaged goods (“CPG”) companies and retailers, and the warehouse fulfillment system and printing space.  While MATW’s business mix is relatively diverse, one commonality is that the majority of its business units have demonstrated flat to negative organic growth trends.

     

    We believe that over the past five years, MATW has attempted to mask its weak organic growth with a string of debt-financed acquisitions that have artificially boosted the Company’s reported growth in revenue and EPS but have destroyed material shareholder value.  These acquisitions have not helped Matthews diversify into healthier and higher growth businesses but have instead doubled down on the same challenged segments. The Company has further obfuscated its weak operating performance by presenting investors with adjusted EPS and EBITDA metrics that exclude large cash acquisition integration and productivity charges.  We question the propriety of these charges since they have remained stubbornly high for the past four years but have not resulted in material synergies or operating margin improvement. Finally, MATW provides weak disclosures that serve to confuse investors and make the Company’s superficial financial metrics seem much better than they really are.

     

    It is unclear whether MATW’s core business is in a steep secular decline or whether its acquisitions and integration charges have yielded extremely poor financial returns.  However, either scenario should ultimately result in substantial share price degradation. We believe that MATW is running out of levers to pull to continue representing an unrealistically favorable view of its financial results and, over the coming year, we expect that investors will gain a clear understanding of the challenges facing the business.  The Company’s high debt levels should limit its acquisitiveness going forward and the SEC appears to be taking notice of the Company’s aggressive accounting policies.

     

    On February 20, 2018, the SEC wrote a letter reviewing the Company’s filings, which raised several important questions about the adequacy and propriety of the Company’s financial disclosures.  We believe this SEC correspondence highlights many of the key issues that underpin our short thesis on MATW. These comments can be boiled down to the following arguments: 1) the Company does not disclose its organic growth or the factors underlying its revenue growth (or lack thereof); 2) MATW has been adjusting its results for high level acquisition-related “one-time” charges, but has not provided information around the nature of these costs or the benefits they are expected to yield; and 3) MATW has provided poor disclosures around the sustainability of other items that have artificially boosted its EPS growth like its unusually low tax rate and unconventional EPS add-backs.

     

    We cannot be sure that the SEC comments will lead to an investigation or a larger restatement of the Company’s financials, which would clearly benefit our short position.  However, regardless of the SEC’s course of action, we believe that MATW will have increasing difficulty meeting analyst estimates due to the secular pressures on its businesses.  MATW’s management should be on notice that regulators are taking a closer look at its aggressive accounting practices and thus may take a more cautious approach on non-GAAP earnings adjustments and other tactics that have artificially boosted recent results.

     

    We believe that the market should become aware of Matthews’ deceptive tactics over the coming quarters as the Company’s financial performance deteriorates.  We expect MATW’s fiscal year ending September (“FY”) 2019 adjusted EPS to come in at $3.80 or worse, well below current market consensus expectations of $4.30.  When one includes accounting costs that MATW excludes, but its peers do not, this translates to actual EPS of $2.90. Using comparable multiples of small- and mid-capitalization memorialization, print marketing, and industrial companies and our below consensus numbers, we arrive at a price target of $31.52 to $36.92, representing between 39% and 48% downside for the shares.

     

    Company Description

     

    Matthews International operates in three reporting segments: Memorialization (40% of last-twelve-months (“LTM”) sales); SGK Brand Solutions (51% of LTM sales) and Industrial Technologies (9% of LTM sales).  The memorialization segment sells caskets to funeral homes, bronze and granite memorials to cemeteries and cremation equipment and services. The SGK brand solutions segment provides printing support and creative design to retailers and CPG customers to assist with product packaging and merchandising displays.  This segment also provides tooling, such as cylinders and plates for printers, to assist its CPG and retailer customer base. Lastly, the industrial technology segment provides inkjet, thermal and laser marking products and warehouse fulfillment systems to industrial and warehouse customers to assist in sorting and tracking products.

     

    Prior to its recent acquisition binge, MATW was a company with low financial leverage, stable cash flows and slow organic growth.  At the beginning of FY 2013, MATW’s debt-to-LTM EBITDA was 2.0x, and had been around those levels for several years. However, starting in FY 2014, MATW began an aggressive acquisition program that has dramatically increased its financial leverage.  The biggest acquisitions were Schawk (SGK) in FY 2014, a printing and marketing business for CPG companies and retailers, and Aurora Casket Company (“Aurora”) in FY 2015, the third largest burial casket manufacturer. However, the Company has supplemented these larger acquisitions with a string of smaller deals.  Over this period, MATW has spent a little over $1.3 billion on acquisitions and related integration costs, taking its leverage up to 4.1x net debt-to-adjusted EBITDA. Thus far, investors have applauded MATW’s strategy with its shares returning 52%, compared to a 43% return for the Russell 2000, since the day before the Schawk deal on March 17, 2014.  However, with the pace of acquisitions slowing, we believe that future share price performance will be much worse.

     

    Poor Execution on Acquisition Roll-Up Strategy

     

    While MATW’s acquisition binge has clearly benefited revenue and EPS due to a low-cost debt environment, we believe that the Company has destroyed substantial shareholder value.  We do not know whether the value has been destroyed by poor acquisition performance or declines in the core business, but either scenario should result in material share price declines.

     

    Since the beginning of FY 2013, MATW has made net acquisitions and investments totaling just under $1.2 billion and taken restructuring and strategic charges of $177 million for a total spend of over $1.3 billion.  Meanwhile, from FY 2013 to FY 2018, adjusted EBITDA is expected to have increased by a mere $94 million based on analyst estimates (which we believe are aggressive). This implies that MATW has essentially paid 14.1x for the additional EBITDA it has created over this period, assuming that EBITDA in the core business has not grown over the past five years.  However, most companies that trade at MATW’s multiple would have been expected to have generated at least a 5.0% organic EBITDA CAGR over the past five years of economic expansion. If we assume that scenario, it implies that MATW paid a ridiculous 26.6x EBITDA for its acquisitions and related synergies.

     

    Moreover, since MATW focuses investors on its free cash flow generation, we should consider EBITDA minus additional capital expenditures from acquired companies as well.  On this score, capital expenditures over the last-twelve-months are $29 million higher than they were in FY 2013. This means that MATW has paid approximately 20.3x EBITDA minus capital expenditures for its acquisitions over this period, if we assume stagnant growth in the core business.  Even with the current low tax environment, this equates to a dismal 3.7% after-tax return on the capital MATW has invested in this period. This rate of return is well below the Company’s cost of capital and even below the cost of debt on the Company’s recently issued bonds. Therefore, we believe that either the core business is performing extremely poorly or the Company is destroying value with its active acquisition strategy.

    MATW’s track record of adding value to companies it acquires also appears poor.  MATW has only detailed the revenue contribution from its largest two acquisitions, Schawk and Aurora, but the Company’s performance in both deals was not encouraging.  In the case of Schawk, it appears that the Company’s revenue declined by 6.5% in its first year of MATW’s ownership. Meanwhile, Aurora declined by a shocking 10.0% in the first year of MATW’s stewardship.  Nevertheless, in that timeframe, the stock appreciated by 53%.

     

    In summary, it is hard to argue that MATW has added value from its acquisition program unless you believe that declines in the core business are much worse than they appear.  If this is the case, these pressures will be more problematic for Matthews with the higher leverage incurred as part of these deals. Additionally, we believe the Company’s EBITDA contribution is even lower than it appears and that MATW has been overly aggressive in recognizing acquisition integration charges.

     

    Matthews Faces Secular Pressures that Have Resulted in Organic Revenue Declines

     

    We believe that MATW faces significant secular pressures in its core business lines that should lead to disappointing revenue growth once the pace of its acquisitions slows.  The memorialization segment faces secular growth headwinds as increases in the number of people choosing cremation over traditional burial should cause volume declines for the foreseeable future.  Furthermore, consumers have shown a tendency to choose cheaper caskets and memorials in recent years. These trends have caused competitor Hillenbrand (HI) to guide the market to -1.0% to -3.0% revenue growth in its casket segment for the foreseeable future.  Moreover, HI believes that it needs to pursue an aggressive restructuring program to even maintain margins at current levels.

     

    Meanwhile, SGK Brand Solutions continues to be pressured by weak spending from large CPG companies, faced with competition from smaller brands, private label and internet retailers.  These issues have been exacerbated by the digitalization of printing and pressure on print advertising budgets as more dollars flow online. MATW continues to call for a snap-back in growth in this segment referencing large customer wins in the private label space.  However, we believe that these wins will be largely offset by attrition elsewhere as MATW’s client base is clearly struggling. Finally, while the industrial technology group should be able to grow faster than the other two segments, it is small and has also produced weak levels of organic growth over the past several years.  This suggests that the Company’s product portfolio is poorly positioned. The Company hopes to re-invigorate its growth in this segment with a new printer that can print on non-paper substrates. However, even if this product is an overwhelming success, it will be hard for it to move the needle in light of the weak growth in the other segments.

     

    To date, MATW has been able to mask its weak organic growth with acquisitions.  However, unlike the majority of public companies, MATW does not detail the impact of acquisitions on its growth rates.  This practice has caught the attention of the SEC. In the SEC letter to MATW, they clearly state that the Company should “[q]uantify the impact acquisitions had on revenues, gross profit and operating profit for all periods presented.”  In response, MATW argues “the impact of acquisitions on the Company’s financial results cannot always be determined with precision due to the nature of our businesses and the integration of these newly-acquired companies into our core operations.”  This is a deceptive response to the inquiry because, as MATW readily admits, if the Company chose to do so, it could easily quantify the historical sales of the acquired operations and present a pro forma growth disclosure. Moreover, for charges related to acquisitions, Matthews seems to have no problem differentiating “one-time” expenses from ongoing operating costs.  We believe that the Company intentionally chooses not to provide this information because its growth has been so poor.

     

    Due to the secular headwinds facing MATW’s business, the Company’s sales appear to have declined organically over the last several years despite a strong economic backdrop.  In order to solve for organic growth, we have scoured the Company’s disclosures on the revenue run-rates of recent acquisitions and made assumptions on acquisition price-to-sales multiples where historical revenue is not disclosed.  Based on our analysis, the Company’s organic revenue has shrunk at a -1.8% CAGR when adjusted for currency and acquisitions over the last two years. This has been driven by -3.1% organic growth for SGK Brand Solutions, -0.4% growth in Memorialization, and -0.3% growth for Industrial Technologies.  More recently, trends do not appear to have improved in the first half of fiscal 2018, with organic growth further slowing to -2.4% despite accelerating macroeconomic trends in most other sectors.

     

    While few investors are willing to do the work to solve for MATW’s organic growth at this point in time, the Company’s poor rate of growth should become apparent in the near future.  MATW is currently well above the high end of its leverage targets and should not be able to make as many acquisitions on a go-forward basis as it focuses on deleveraging. Furthermore, over the past year, currency has been a substantial tailwind to top line growth.  However, if currencies remain where they are, it will become a headwind to growth in the coming quarters. In FY 2018, we estimate that currencies will add approximately 2.0% to MATW’s reported revenue growth, but at current rates they should detract around 0.6% in 2019.  Similarly, acquisitions are likely to add 6.0% to MATW’s growth in 2018, but with the acquisitions consummated thus far we estimate the benefit will be only 1.3% in 2019.

     

    Finally, several of MATW’s businesses have large orders that can substantially impact the Company’s growth rate in a given quarter, but MATW often fails to mention the benefit it received from these orders.  Based on our due diligence, one such order was a large in-store display contract for a global electronics company that benefitted last year’s June quarter revenues in its SGK brand solutions business by approximately $15 million or 7.5% of revenue.  This order received no mention in the Company’s earnings call that quarter but will likely be discussed if the Company posts weak results in that segment in the current quarter. Since MATW has been highlighting large customer wins in this business, many investors are optimistic about its growth potential in the coming quarters.  Therefore, we believe that these investors may be disappointed with MATW’s growth in that segment in the June quarter as this slow growth business anniversaries such a large order that had not previously been openly disclosed.

     

    In conclusion, we see little evidence that MATW can demonstrate the organic revenue growth rates to hit analyst targets if it slows down its accelerated pace of acquisitions in order to reduce debt.  Therefore, the Company will need to significantly increase its margins to grow earnings in the future. However, we believe that the outlook for future margin expansion is equally bleak.

     

    High Level of Questionable Charges Appear to Have Overstated MATW’s Earnings

            

    Since the acquisition of Schawk approximately four years ago, MATW’s earnings and EBITDA have been adjusted for large acquisition and integration charges despite the fact that MATW’s major acquisitions were consummated in fiscal years 2014 and 2015.  While it is a common practice to exclude acquisition integration and special items, MATW’s acquisition and integration charges have recurred for an unusually long period of time and remain persistently high. In the past four and a half years, adjusted earnings per share excluding acquisition and integration charges have been 34% higher than they would have been had MATW not excluded them.  Moreover, in the last twelve months, adjusted earnings per share are still 26% higher without charges even though we are now well beyond a typical acquisition integration period.

     

    SEC Questions Propriety of MATW Non-GAAP Disclosures

    The SEC has noticed this issue and raises two relevant questions.  First, the SEC asked “[w]e note that you adjust for acquisition-related items in arriving at your various Non GAAP measures.  Please tell us and expand your disclosure to address the underlying nature and material cost components of this adjustment. Please explain how you concluded that these expenses are not normal, recurring, cash operating expenses necessary to operate your business.”  To answer this question, MATW suggested that it had told investors that acquisition integration costs would “continue for an extended period of time” due to “the significant size and projected synergy benefits from integration.” While MATW defended its definition of acquisition costs, the Company did reassure regulators that “acquisition-related items declined significantly in the fiscal 2018 first quarter compared to the prior period reflecting that the integration efforts for the acquisitions are nearing completion.”  Perhaps coincidentally, FY Q1 2018 was a very weak quarter with adjusted EBITDA declining by 8.2% despite substantial benefits from newly acquired businesses and currency. Moreover, in FY Q2 2018, acquisition costs and special items returned to their previous levels and actually increased by 4.6% on a pretax basis. Interestingly, this quarter demonstrated a much improved 7.1% growth in adjusted EBITDA.

     

    Second, MATW should be earning some financial return on all of these one-time integration and productivity initiative charges since they are essentially capital investments to achieve substantial future synergies.  On this score, the SEC asked MATW to “[q]uantify the benefits of productivity initiatives and realization of acquisition related synergies.” Unfortunately, these charges appear to have yielded little in the way of financial benefits.  The SGK brand solutions business has been the beneficiary of the majority of this spending and its LTM adjusted EBITDA margins are exactly in line with 2015 levels at 13.3%. Similarly, the memorialization segment has improved its margins by a mere 60 basis points since 2015, a level of margin improvement that most companies would typically attribute to continuous improvement initiatives.  Therefore, we believe that either the businesses are experiencing significant pressure on their margins and synergies are helping to hide these issues, or these charges are not as “one-time” as MATW would have investors believe.

     

    Taken as a whole, we believe MATW’s disclosures around its acquisition strategy are logically inconsistent.  In MATW’s responses to the SEC’s questions on organic growth, management claimed that the majority of its acquisitions are integrated so seamlessly that it cannot tell the difference between organic growth and acquisition-related growth.  However, the Company appears to have no difficulty distinguishing between “one-time” costs related to acquisition integration and everyday costs of running its business. Moreover, in fiscal 2015, MATW was forced to disclose weaknesses in internal controls due to a $15 million theft of Company funds by a long-time employee.  If MATW’s accounting systems are not precise enough to catch $15 million of cash going out the door, we are skeptical that they can precisely separate on-going and one-time expenses. If we are correct that some of MATW’s acquisition related costs are really recurring costs, margins should come under pressure from reduced charges going forward, assuming the Company indeed fulfills its commitments to investors and the SEC.  In fiscal 2019, MATW has committed to reduce its charges by approximately $13 million, representing a $0.29 headwind to EPS.

     

    MATW’s Creditors Have a Divergent View on Acquisition Integration Charges and Timing

    The SEC letter has an interesting section about the sparse information that MATW provides about its debt covenants, which highlights the egregious nature of MATW’s acquisition-related charges.  SEC investigators asked MATW for the following information: “Your disclosures should include actual ratios/amounts for each period and the most restrictive required ratios/amounts. Please show the specific computations used to arrive at the actual ratios with corresponding reconciliations to US GAAP amounts.”  While we do not know why the SEC asked for improved disclosure around MATW’s covenants, we believe that this question has significant implications.

     

    In many cases, companies that make substantial non-GAAP adjustments to their financial results justify their adjusted EBITDA by stating that it matches a similar metric in the credit agreement.  We believe that this is interesting because a careful read of MATW’s credit agreement shows that lenders do not have as permissive a view of charges as the adjusted EBITDA and EPS that MATW presents to investors.  According to MATW’s credit agreement, the Company may only exclude acquisition integration expenses to the extent that they occur within 18 months of a permitted acquisition. However, for adjusted EBITDA and EPS purposes, MATW still claims to be taking charges to integrate the Schawk acquisition which closed in July of 2014.  In our experience, 18 months is a much more typical integration period than the five years that the Company tells its investors that acquisition integration costs can persist.

     

    Other Financial Shenanigans

     

    MATW also uses several other accounting gimmicks that have benefitted recent period earnings but will likely become headwinds in future periods.  We believe that investors have not seen through these practices because MATW’s disclosures are so poor and confusing.

     

    Low Tax Rate Benefitted FY 2017 and FY 2018 and Will Pose a Significant Headwind to FY 2019

    One such item that has substantially benefitted earnings in recent periods is an extraordinarily low tax rate used to calculate adjusted EPS.  In FY 2017, which did not benefit from the new tax law, MATW saw its adjusted tax rate decline from 31.0% in FY 2016 to 23.5% in FY 2017. This allowed MATW to report a healthy 6.5% increase in adjusted EPS, but if the tax rate had remained constant, EPS would have declined by approximately 4.0%.  Similarly, in fiscal Q1 2018, MATW’s tax rate declined to a mere 10.5% despite the fact that the Company had yet to benefit from 2018 tax reform. This reduced tax rate allowed the Company to show a 3.3% decline in EPS versus a 24.4% decline had tax rate remained at the expected 30.0% level. This low tax rate was the difference between MATW beating consensus EPS expectations by $0.03 and missing by $0.11.  

     

    If the Company believes that it is creating value through strong tax planning, we believe that it should highlight the low tax rates it has been paying in recent periods.  Instead, the Company has made its disclosures around taxes and extraordinary items so confusing that few investors understand what the adjusted tax rate was in any given period.  MATW does not clearly reconcile its non-GAAP earnings on a pre-tax and after-tax basis, so many investors are unaware of the unusually low tax rates that the Company is enjoying. To this point, one of the sell-side analysts who follows MATW simply hard codes for adjusted EPS and does not even bother reconciling GAAP and non-GAAP EPS in a more granular fashion.  The SEC appears to have noticed the impact of tax rates on MATW’s adjusted EPS and requested that MATW provide improved disclosures around the drivers of its extremely low tax rate. Furthermore, the SEC requested that MATW “disclose the tax effect of [its] non-GAAP adjustments as a separate reconciling item and address how the tax effect was calculated.”

     

    We believe that MATW will face significant EPS headwinds from its tax rate in FY 2019 versus FY 2018.  The Company has guided investors to a normalized tax rate of approximately 26.0% under the new US tax policy, but we estimate that MATW’s FY 2018 tax rate may be around 21.5%.  Since the Company’s fiscal year ends in September 2018, MATW only benefited from tax reform for three of its four quarters. Therefore, some investors may be expecting MATW to benefit from lower taxes in 2019.  However, if MATW’s tax rate reverts to 26.0%, this suggests that the Company would need to grow its pre-tax income by 16%, in order to achieve consensus EPS growth of 9%. Moreover, given a recent bond issue and increased rates on MATW’s floating rate debt, the Company should face $0.10 of additional EPS headwinds in fiscal 2019, meaning that adjusted operating profit will have to grow by around 19.0% to meet analyst EPS expectations.  Based on these headwinds, we believe that it will be difficult for MATW to grow its earnings at all in fiscal 2019, and that it will actually earn $3.80, compared to street expectations of $4.30.

     

    Other Non-Traditional EPS Add-Backs Overstate MATW’s Earnings Relative to Comparable Companies

    MATW is extremely aggressive in other add backs to net income that it uses to derive its adjusted EPS.  While some companies exclude acquisition-related amortization of intangible assets from their adjusted EPS, these companies do not refer to this metric as adjusted EPS.  Instead, they typically call their earnings “Cash EPS.” Moreover, many acquisitive companies that are used as valuation comparables for MATW, do not exclude this item from EPS, making MATW more expensive than it looks on the surface.  MATW also excludes all pension expenses other than the service cost component from both adjusted EPS and EBITDA because the Company claims that this is the truest measure of pension costs. This practice is extremely unusual and we are hard pressed to find another company who reports adjusted EBITDA or EPS in this fashion.  In total, these two exclusions have inflated MATW’s reported EPS by 27% even if one accepts all other charges in adjusted EPS as legitimate.

    Therefore, MATW’s P/E ratio of 15.2x analyst estimates for 2018 may seem reasonable on the surface, but in fact it actually trades at a much higher 19.4x P/E multiple on an apples-to-apples basis.  For the purposes of our analysis, we have evaluated MATW’s valuation relative to its peers using EPS estimates that are calculated in a comparable way. After all, MATW already benefits from much larger exclusions of “one-time” charges than its comparables.  MATW also has substantially more debt than its peers, further enhancing its reported EPS. When we adjust our fiscal 2019 estimate of $3.90 in EPS for these non-traditional add-backs, we arrive at an apples-to-apples EPS estimate of $2.90.

     

    Finally, in the past, MATW has been benefitting by making acquisitions and funding them with very low-rate borrowings on its credit facility, thereby making almost any acquisition immediately accretive.  However, if the Company honors its commitment to de-lever, it will earn a low 2.0% after-tax return on any capital it deploys to pay down debt rather than make acquisitions. To illustrate, if the Company spends $100 million to make a debt-funded acquisition at 8.0x adjusted EBIT, it creates $0.23, or around 6.0%, of EPS accretion.  If MATW uses that same $100 million to pay down debt, the EPS accretion is a mere $0.06, or around 1.6%. Since MATW is far more levered than the majority of its peers, this should further pressure its relative EPS growth going forward.

     

    Memorialization To Face Significant Operational Headwinds in the Coming Quarter

     

    In addition to the questionable accounting, we expect MATW to face substantial margin headwinds in its memorialization segment over the coming year.  First, the memorialization segment has benefited from higher than average death rates over the last year partially driven by a more virulent flu season.  This usually reverts to the mean the following year causing volume headwinds to the business. Even modest volume declines can pressure margins as this business is vertically integrated and has high fixed costs.  MATW has large manufacturing facilities and delivers products to its customers on fixed routes with its own internal distribution operation. As volumes slow, this should result in an increase in per-unit manufacturing and distribution costs.  Moreover, this segment should face cost headwinds with dramatic increases in steel, wood, bronze, and fuel costs. Since MATW pre-buys many of its raw materials, it has yet to be impacted by these raw material shocks but should face pressure in the coming quarters.  Historically, it has been difficult to pass these price increases on to consumers. While MATW may increase prices to funeral homes and cemeteries, this usually results in mix downs where consumers buy cheaper, lower-margin caskets and memorials, nullifying the benefits of pricing.

     

    In fiscal 2012, a year where MATW saw rising commodity input costs and lower casketed burials, the Company saw substantial declines in adjusted operating profits on modest sales decreases.  In this period, sales declined by a mere 2.9% (although MATW made a modest acquisition, so the organic decline was slightly higher). However, adjusted operating margin declined by 240 basis points resulting in a 17% decline in adjusted operating profits.  We believe that 2019 will present a similarly difficult situation as MATW copes with a tougher comparable in terms of death rates and faces an inflationary cost environment. However, analysts are looking for margin expansion in this segment next year.

     

    In summary, analysts are expecting a little over 100 basis points of EBITDA margin expansion from MATW in fiscal 2019 versus 2018.  We believe that this target will be extremely difficult to achieve while the Company is facing headwinds in its memorialization segment and reducing acquisition related charges.  Therefore, our EPS estimates for fiscal 2019 are well below consensus expectations.

     

    Valuation and Conclusion

     

    In summary, we believe that it will become increasingly difficult for MATW to meet consensus expectations for revenue and earnings growth in the coming quarters and year.  The Company has a poor track record of organic growth and has shown little ability to improve its margins despite spending aggressively on acquisition-integration and productivity initiatives and aggressively using accounting gimmicks to mask this lack of growth.  Thus, even if the SEC does not conduct a further investigation, we believe Company fundamentals will result in material downside to the shares.

     

    On a go-forward basis, MATW will have a constrained ability to grow through acquisitions as investors are expecting the Company to meet its deleveraging commitments.  We believe that these acquisitions and related charges have hidden major secular growth and margin challenges in the Company’s core business lines. Moreover, in the coming year, the Company will face substantial headwinds from margin pressure in its memorialization segment, higher interest rates on its debt, higher tax rates, and less ability to exclude “one-time” charges from its adjusted results.

     

    Due to its diverse and generally unrelated business segments, it is difficult to find a perfect comparable company peer group for MATW.  However, we looked at several peer companies that participate in similar printing, marketing, memorialization, and industrial business segments and found that peers are trading at 12.7x FY 2019 P/E and 7.7x FY 2019 EV/EBITDA, which seems fair for a company with Matthews’ limited growth prospects.  Based on these multiples we arrive at a price target of $31.52 to $36.92, representing between 39% and 48% downside for the shares.

     

    Moreover, our estimates are based on a continuation of the current favorable macroeconomic climate.  In a weaker environment, MATW could see significant EBITDA declines and given its high financial leverage, may face covenant violations, resulting in substantially more downside risk for the shares.

     

    Any forward-looking opinions, assumptions, assessments, or similar statements constitute only subjective views. This information should not be relied on for investment decisions and is subject to change due many factors, including fluctuating market conditions and economic factors.  Such Statements involve inherent risks, many of which cannot be predicted or quantified and are beyond our control. Future evidence and actual results could differ materially from those set forth in, contemplated by, or underlying these Statements, which are subject to change without notice.  In light of the foregoing, there can be no assurance and no representation is given that these Statements are now, or will prove to be, accurate or complete. We undertake no responsibility or obligation to revise or update such Statements.

    I do not hold a position with the issuer such as employment, directorship, or consultancy.
    I and/or others I advise hold a material investment in the issuer's securities.

    Catalyst

    1) Q3 Earnings Report Should Show Weak Growth in SGK Brand Solutions

    2) 2019 Guidance Should Show Limited EPS Growth

    3) Deterioration in Performance in Next Several Qs 

    4) Potential for Further Scrutiny by Regulators

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