M&F Worldwide is the third largest printer of checks and other forms for financial institutions and their consumers. Late last year, MFW announced its intention to acquire JH Harland (JH), the second largest participant in the industry, for cash. The resultant combination will effectively make the business of printing checks a duopoly (with DLX the other participant). We believe the combined company generates a 15% free cash flow yield on pro forma, trailing results; this FCF yield could easily reach 25% or higher with reasonable synergy assumptions, which we believe are easily achievable after the acquisition closes later this year.

 

MFW is a holding company with two different businesses: licorice and check printing. The licorice business is stable (~$100MM annual revs) and highly profitable (50% gross margins) and is the preferred supplier of licorice flavorings to the tobacco industry. The check printing business, Clarke American, was purchased from Honeywell in late 2005. The business provides checks and other financial forms (e.g. deposit slips) to major financial institutions and thru a small direct to consumer effort and generates ~$625MM in revenues at 39% gross margins.

 

JH Harland operates in three major segments: printed products (identical product line to MFW), financial software, and Scantron (e.g. the little bubble sheets you filled out in grammar school to take tests). The software and services business is part of a relatively new effort by management to cobble together some 21^st century products (e.g. CRM computer software) to their banking clients. While this business has generated good gross margins, it has produced little at the operating level for the last two years (~$170MM annual revenues, 62% gross margins, single digit operating margins). They have been spending the significant cash generation from the printed products business to fund this attempt at diversification for the last several years, likely at the expense of shareholder value.  Scantron is a very stable business (~$125MM annual revs) and profitable business line (55% gross margins).

 

We harbor no illusions that printing checks and deposit slips for financial institutions is a growth business. The Federal rEserve estimates that the number of written in the U.S. declined approimxtley 4% annually between 2000 and 2003 and is expected to decline in the low single digits each year thru the end of the decade (link 2004 Federal Reserve study: http://www.federalreserve.gov/BOARDDOCS/PRESS/Other/2004/20041206/default.htm).  Despite these declines, Americans utilize checks for over 35 billion payments each year, and banks continue to rely on the basic checking account as the source of the primary relationship with both individual and business accounts. While the business of providing checks, deposit slips, checkbook covers, recording registers and the like is mundane, it generates quite a bit of cash, requires little in maintenance capital, is unlikely to attract new entrants, and will not disappear completely anytime soon. In this situation, an investor is clearly more than compensated for the lack of growth thru a rich free cash flow yield and low valuation.

 

The advantages of a Clarke American / JH Harland combination are fairly obvious. The combined check printing businesses will have $1.3B in revenues, $760MM in cost of goods sold and $340MM in SG&A.  The Scantron and licorice businesses, while non-core, are profitable and cash flow generative, and the JH software division could be sold, spun-off or even shutdown. We believe the combination of these companies represents an excellent opportunity for the proven, effective Clarke American management team to cut significant costs from the enterprise.

 

As previously mentioned, MFW is buying JH for cash consideration of $52.75 per share, plus assumption of all debt outstanding, for an enterprise value of approximately $1.7B. Our understanding is that MFW is currently in the market to raise the debt to fund the acquisition. While we are not privy to these efforts or negotiations, the “chatter” is that $100MM in synergies is being mentioned as a reasonable level. Furthermore, we have heard that MFW may actually seek to re-finance, at an advantageous all-in rate, a substantial portion of the $725MM in senior secured notes, term loans, and senior notes they issued in late 2005. We have not modeled in any interest rate improvement as part of our synergies, and have assumed MFW pays a 10% blended interest rate for the $1.7B required to purchase JH.  Pro forma for the transaction, the new MFW would be levered at just under 6x trailing, pro forma, pre-synergy, EBITDA.

 

Pro Forma Capitalization
MFW Shares Outstanding		20.6
Share Price		$   32.20
Market Capitalization		663
MFW Net Debt		666
Current MFW Enterprise Value		1,330
Debt Required to Fund JH Acquisition		1,700
Pro Forma MFW/JH Enterprise Value		3,030
Pro Forma MFW/JH Debt		2,366
PF MFW Mkt. Cap (Unchanged)		$663

 

Because none of the business lines involved in this analysis is seasonal, for the sake of brevity and accuracy, we have simply annualized the financial results for the 9 months ended September 30, 2006 to illustrate the earnings and free cash flow potential of the combined MFW / JH. As the table below illustrates, assuming $75MM in synergies on the COGS line (~10% of combined COGS) and $25MM at the SG&A level  (~7.5% of combined) yields north of $4 in pro forma EPS and nearly $500MM in combined EBITDA (with $125MM in pro forma D&A).

 

$ in Millions	Pro Forma Check Printing Business					Legacy Businesses
9 Mths Ended		Clarke	Pro Forma		Pro Forma			Mafco	Consolidated
9/06 Annualized	JH Harland	American	(Pre-Synergies)	Synergies	(W/ Synergies)	Scantron	Software	(Licorice)
Revenues	$            658	$            633	$             1,291	$               -	$           1,291	$            118	$            277	$              97	$          1,784
COGS	371	392	763	(75)	688	53	107	50	898
Gross Profit	287	240	527		602	65	171	47	885
Gross Margin	43.6%	38.0%	40.8%		46.7%	55.2%	61.5%	48.6%	49.6%
SG&A	191	149	340	(25)	315	37	144	16	512
EBIT	96	91	187		287	28	27	31	373
Operating Margin	14.6%	14.4%	14.5%		22.2%	23.5%	9.7%	32.2%	20.9%
Less: Pro Forma Interest (Assumes historical rate for MFW legacy debt; 10% on transaction related debt)									238
Pre-tax Income									135
Less: Taxes (35% Assumed Rate)									47
Pro Forma Net Income									88
Pro Forma Shares Outstanding									21
Pro Forma EPS									$4.18

 

We believe that the run rate annual free cash flow for both MFW and JH is approximately $100MM, respectively.  A 10% interest rate for new debt and 35% tax rate results in approximately $111MM in new interest expense. Our assumption of $100MM in pre-tax synergies yields $65MM in after-tax cash flow, resulting in a combined free cash flow of approximately $155MM. We have not factored in improvements in working capital at this time.

 

Pro Forma Free Cash Generation
MFW Free Cash Flow	$100
JH Free Cash Flow	100
Less: New Interest	(111)
Plus: Synergies	65
Pro Forma  FCF	$155

 

Our estimate of $100MM in synergies is not scientific, nor is it precise. We do believe it is realistic, probably conservative and supported by the scuttlebutt from the debt markets. We note the following in assessing the achievability of these targets:

 

-         $75MM on the COGS line represents approximately 10% of combined COGS for the checking printing businesses

 

-         $25MM on the SG&A line represents approximately 7.5% of combined SG&A for the checking printing businesses

 

-         MFW currently operates 11 check and form printing centers in 9 different locations; JH operates 18 production and distribution centers in 14 different locations

 

-         MFW reported 3,600 employees as of 12/31/06; JH reported 5,700 employees

 

-         The Clarke American management team strikes us as a group of cost conscious, effective operators. This business was operated as a unit of Honeywell for several years and management is adept at operating in a capital constrained, results oriented environment.

 

The pro forma MFW-JH will be nearly identical in size to the aforementioned Deluxe Checking (DLX). Post-synergies, however MFW will be a much higher margin business. A brief snapshot of DLX’s valuation multiples are as follows:

  

DLX Checking - Summary Metrics
Dollars in Millions, 9 Mths Ended 9/06 Annualized
Revenues	$          1,617		Market Cap	$          1,429
COGS	610		Plus: Net Debt	1,050
Gross Profit	1,007		Enterprise Value	2,479
Gross Margin	62.3%
SG&A	794		EV / EBITDA	8.2x
EBIT	213		P/E	15.4x
Operating Margin	13.2%		FCF Yield	12.9%
EPS	$1.80
EBITDA	301
FCF	185

  

Simply applying the metrics currently applied to DLX yields the following:

 

Pro Forma MFW at DLX Multiples		$100MM Synergies
	FCF	EPS	EBITDA
Pro Forma Result	$155	$4.18	$       500
Assumed Multiple	7.7x	15.4x	8.2x
Implied Enterprise Value			$    4,119
Less: Net Debt			2,366
Equity Value	1,195		1,753
Shares Outstanding	20.6		20.6
Share Price	$58.03	$64.48	$ 85.10
Increase from Current	80.2%	100.3%	164.3%

 

Given the low-growth, high cash flow, and highly-leveraged nature of the pro forma MFW-JH, we look at the company’s free cash flow yield as the most relevant metric for valuation. A simple move from the current prospective free cash flow yield of ~23% to a more DLX-like yield of ~13% provides 80% price appreciation from this point. As a combined MFW-JH will actually be a higher margin, better managed and slightly more diversified enterprise than DLX, perhaps it deserves a premium valuation, but we have not put that into our price targets. 

 

Interestingly, we believe at current market prices, MFW is discounting a “no synergy” scenario for the combined company (again using FCF yield as our primary valuation metric). In other words, even after MFW’s run from $18 to over $30, we do not believe investors are “paying up” for synergies:

  

Pro Forma MFW at DLX Multiples		$0MM Synergies
	FCF	EPS	EBITDA
Pro Forma Result	$         90	$1.09	$       400
Assumed Multiple	7.7x	15.4x	8.2x
Implied Enterprise Value			$    3,296
Less: Net Debt			2,366
Equity Value	692		929
Shares Outstanding	20.6		20.6
Share Price	$    33.62	$    16.77	$    45.12
Increase from Current	4.4%	-47.9%	40.1%

 

 Risks & Reservations

Given the performance of MFW stock since the announcement of the JH acquisition, we believe the biggest risk to this position is that the transaction does not close. Luckily, since the currency involved in this transaction is cash, and with JH shares currently trading at just under $50, the “arb spread” is just over 5%. Thus far, we have chosen not to hedge out the transaction risk involved in this situation, but should you find the story compelling and wish to seek downside protection, it can obviously be obtained thru shorting JH.  We have no reason to believe the deal will not close, but can think of a few:

 

-         HSR Concerns – This will make check printing a duopoly market, but our understanding is that both DLX and MFW’s customers are actually happy about this as it inserts a level of stability and price rationality into the market for the product.

 

-         Topping Bid – The potential synergies involved in this transaction make it difficult to believe that any non-strategic bidder (e.g. private equity) could make this acquisition work. DLX has had its own fair share of problems, replaced management last year, and seems ill-equipped to make an acquisition at this time. Our checks indicate that management would not be comfortable operating under the heavy debt load that a JH acquisition would require.

 

-         Financing – A change in the financing market (e.g. interest rates or liquidity) could put this deal in jeopardy, given its relatively high leverage level.  Thus far, we certainly have not seen any slowdown in the debt market’s appetite for “LBO-like” offerings.

 

The final risk we see in an investment in MFW, and frankly the element of the situation that gives us the greatest pause, is the prescence of Ron Perelman, private investment vehicle (McAndrew & Forbes) ownes 38% of the equity in MFW.  Needless to say, not all of Perleman’s investments have worked out, though in this case we take comfort in the fact that our interests are for the most part aligned with his as fellow shareholders.