Description

Executive Overview

We believe Monotype Imaging (“TYPE”) is a compelling short candidate with >30% downside. While we admire the business model of Monotype and the growth prospects within certain of its divisions, we view the stock today as a short given the market’s gross misunderstanding of and lack of appreciation for how the company makes money. Additionally, Monotype has poor earnings quality with SBC comprising 24% and 33% of EBITDA and EPS, respectively. Lastly, we are 6%/8% below the street for 2019 and 2020 EBITDA given our segment level modeling which factors in the negative mix shift TYPE is experiencing.

Business Description

Monotype is a leading provider of fonts and font technologies to graphic professionals and consumer device OEMs. The company is organized across two primary business lines: (i) OEM (font rendering software) and (ii) Commercial Professional (font IP) or “CP”. The OEM business was Monotype’s original business line.

Within the OEM segment, Monotype sells software/technology that enables the rendering of fonts on printed documents or on small device screens in a legible, clear fashion. OEM customers include device makers who manufacture printers, copiers, mobile phones, e-readers, tablets, consumer appliances, Internet of Things (“IoT”) devices, etc. as well as independent software vendors / “ISVs”. The OEM business comprises 1/3rd of total sales. We expect the OEM business to decline by ~4% on a top-line basis and see segment EBITDA declines of 6% per annum due to the continued erosion of the printer market.

The CP segment licenses its font IP to large clients, manages several e-commerce website which retail fonts to smaller customers and has two subscription based software businesses (Olapic and Mosaic) which provide and help manage font and other visual content. The CP business comprises 2/3rds of total sales. We model a 5% revenue CAGR and low-double digital EBITDA growth for CP. It's worth noting that the CP business faces meaningful competiton from free sources such as Google Fonts, whose library continues to grow and improve.

Thesis

Our short thesis is predicated on three primary tenets:

Business Misperception

While Monotype markets itself as high-growth font company, the reality is the vast majority of the company’s EBITDA continues to be derived by its legacy OEM business - which is a declining asset. This reality is not well known by the market as the company does not provide segment reporting. However, based on our research, we believe EBITDA margins for the OEM business are in the 70% range versus mid-teens for the font business. This means that while OEM comprises just 1/3rd of revenue (something Monotype continuously reminds investors of), it makes up ~60% of total company EBITDA.

While investors are encouraged by a positive inflection in Monotype’s revenue as its declining OEM business becomes less of a drag on consolidated results, they fail to appreciate the very high incremental margins of this business (which we estimate at 90%-95%). As the legacy business continues to erode it will cause a meaningful drag on total earnings which will be difficult to overcome without a major reduction in costs and should cause greater awareness by the market of how Monotype generates profits.

Earnings Quality

As mentioned, SBC comprises 24% and 33% of EBITDA and EPS, respectively, of Monotype’s earnings. Monotype generously adds these back to its adjusted earnings and has coaxed the market to do the same. However, given the magnitude of the add-backs, this massively distorts the earnings profile of the business. Monotype currently trades at a headline valuation of 10x 2020e EBITDA and 15x 2020e EPS. Adjusted for SBC these multiples rise to 13x 2020e EBITDA and 20x 2020e EPS. On either basis, we believe this is rich for a business with Monotype’s growth outlook.

Earnings Risk

We are 6% and 8% below the consensus 2019 and 2020 EBITDA. This is driven by our segment modeling which takes into account the loss of high margin revenue that is being replaced by lower margin revenue. It does not appear that most analysts model the business this way.

While the company has failed to adjust its annual guidance after a very weak Q1, we believe the company may need to reset expectations when it reports results for Q2 as we view their outlook as aggressive and difficult to achieve.

Valuation & Downside

Given the divergent growth profiles of Monotype’s various businesses, we believe a sum-of-the-parts approach is most appropriate way to value the company. We believe this is something few if any investors do. We apply a 5x multiple to the OEM business and 10x to the CP business. On this basis we arrive at a fair value for Monotype of ~12$ per share or -32% from here (including the payment of dividends).

Risks

The biggest risk to the Monotype short thesis is an acquisition by private equity. (We think it is unlikely a strategic would want to acquire the entire company). In fact, in June 2019, Bloomberg reported that several (unamed) private equity firms had expressed an interest in the company. The press report indicated Monotype is working with advisors to explore alternatives in response. We note the article contained few details and came out after a weak Q1 earnings report and the departure of the company's CFO.

We believe an acquisition by PE could make sense but would likely have to be struck at a lower price. Our LBO model – which assumes 6x leverage and fairly aggressive cost reductions - suggests that a mid to high teens IRR is achievable at ~$16/share.

Monotype previously tried to sell the company in the fall of 2017. 28 parties were ultimately contacted, of which 10 filed confidentiality agreements. According to the company, “no definitive offers were received”. While the stock price was higher then, the business has deteriorated as well. Additionally, as mentioned, Monotype CFO Anthony Callini recently resigned to accept a new role at a start-up music company. In doing so, he left several millions of dollars of change-in-control payments on the table.

Alternatively, investors can express a short view via relatively inexpensive put options to protect downside against a takeout prospect.

I do not hold a position with the issuer such as employment, directorship, or consultancy.

I and/or others I advise do not hold a material investment in the issuer's securities.

Catalyst

Continued decline of OEM business

Guidance reduction