Description
Apologies in advance for posting such a small-cap, but I believe this is a compelling opportunity for investors who can participate. Media Sciences International (AMEX: GFX) is attractively valued at 5.1x ¡¦05 EBITDA, especially considering its revenues are growing at a 20%+ clip. It has strong competitive positioning and offers compelling value to its network of dealers & distributors and end consumers. The Company, which manufactures and distributes generic solid ink sticks and toner cartridges (i.e. consumables) for business-workgroup color laser printers, is characterized by (1) significant insider ownership, (2) extremely attractive valuation, and (3) strong growth prospects.
Media Sciences is the leading generic alternative to the original equipment manufacturers¡¦ ("OEM") ink sticks and toner cartridges for business-workgroup color laser printers. It participates in the value chain as a generic "razor" manufacturer for many branded "blades" (i.e. business-workgroup color laser printers). For example, office managers are able to purchase the Company¡¦s products for use in branded laser printers at 30-40% discount to the price the OEMs currently charge for their own solid ink sticks and toner cartridges. This customer incentive has allowed Media Sciences to capture the most lucrative part of the sale (consumables sales can be as high as three times the revenue that is derived from the original equipment sale over a printer¡¦s life).
In an ongoing effort to increase its product offering beyond consumables for Xerox color laser printers, the Company recently expanded its product line to include Epson, Minolta and Ricoh printers. Similar to Media Sciences¡¦ Xerox products, these consumables generate gross profits of over 50% and are sold under the Media Sciences brand through Staples and Office Depot, as well as under other distributors¡¦ brands, for 30-40% less than the cost of the OEM products.
Market Opportunity ¡V Color in the Office
The office color laser printer market is currently undergoing widespread adoption. This has been driven primarily by the OEMs¡¦ strategy to expand their color printer installed base so as to ensure access to the sales of high-margin color consumables. Consequently, prices for high quality, color laser printers have plummeted below $1,000 at retail, the sweet spot for many technical office appliances. During the last decade, adoption of color printing in offices has fallen short of OEMs¡¦ expectations. The perception among users is that color is too expensive, too difficult, and not necessary for mainstream business applications. However, color is finally gaining a foothold in office printing largely because price/performance ratios for color printers have changed significantly for the better in the last year. In fact, Lyra Research forecasts that worldwide workgroup color laser printer shipments will grow from 838,000 units in 2002 to 2.7 million units in 2007, a 26% CAGR. Additionally, Lyra believes that the color laser printer market represents one of the largest opportunities for office OEMs in terms of hardware and supplies. This is further illustrated by Lyra¡¦s estimate of worldwide revenue from the sale of color laser printer cartridges which it estimates will grow from $2.2 billion in 2003 to $8.0 billion in 2008, a CAGR of 29%.
For further evidence of this transition to color in the office one needs only to read Xerox¡¦s most recent earnings release: ¡§Revenue from color products grew 17 percent in the second quarter and is a key driver of Xerox's growth strategy as the increasing volume of pages printed on Xerox's color systems flows through to post-sale revenue. Color revenue now represents 25% of Xerox's total revenue.¡¨ Media Sciences has approximately 5-6% market share of Xerox¡¦s printers, meaning there is plenty of opportunity to grow share. Market share is even lower for other manufacturers¡¦ printers, which it just recently began supporting.
In order to further extrapolate the potential size for generic consumables in the color market, it is helpful to look at today¡¦s monochrome (black & white) market. Currently, one out of five monochrome cartridges is a generic cartridge. If that same statistic is applied to the color printer installed base today, the market potential for generic color printer consumables is $500-600 million (and growing +20%). The company¡¦s growth strategy entails capturing share away from the OEM¡¦s consumables. As the leading manufacturer in this niche, it is not inconceivable that the Company can eventually capture 10-15% of this market over a five year period, which implies revenues of $50-$90 million. The Company expects to report revenues of $17 million for their fiscal year ending June, 2004.
Value Proposition
Media Sciences offers a compelling value to its network of dealers & distributors and end consumers. Its products offer an alternative to the OEMs¡¦ without sacrificing quality. The Company creates an incentive for its network of dealers & distributors by affording them the opportunity to earn up to three times the profit margin over comparable OEM branded products while guaranteeing its products via warranty. Thus, the Company is able to offer an attractive value proposition to the entire demand chain while retaining 50%+ gross margins.
Printer* OEM Offering Media Sciences Offering
MINOLTA-QMS 330 $167.00 $135.00
TEKTRONIX PHASER 560 $362.99 $230.00
TEKTRONIX PHASER 840 $195.99 $136.00
TEKTRONIX PHASER 2135 $313.99 $258.00
* Represents 4 of 25 total printers Media Sciences supports.
INKlusive Progam = Annuity Revenue Stream
In addition to driving sales via its network of dealers and distributors, Media Sciences¡¦ strategy is to create a new set of color printer users who are contractually committed to the Company¡¦s products while significantly lowering the customers¡¦ total cost of ownership. Via the Company¡¦s INKlusive color printer program, businesses receive a high quality Xerox color printer and technical support for free with the contractual obligation to purchase solid ink sticks each month for a 24-month period. Furthermore, the printer is offered by a third party leasing Company (GreatAmerica Leasing Corporation) and does not impact the Company¡¦s balance sheet. Currently the Company offers this program for the Phaser 8200, but beginning in late August, the Company will begin offering the Phaser 8400 as well. If you¡¦ll notice in Xerox¡¦s latest conference call, it mentions the "Phaser 8400 was wildly successful." Equally impressive, with a simple Google search you will find a number of "Ebay-type" businesses that have partnered with Media Sciences to sell this program (http://www.freeprinters.com). This is a testament to Management¡¦s creativity to penetrate and lockup this high growth market.
Capital Structure/Preferred Stock Conversion/Additional Equity Commitment
Media Sciences recently converted all preferred shares into common shares. This will allow the Company to recapture $1.4 million in cash that was previously diverted to preferred holders. The Company has stated that the recaptured money will be used "for investments in new product development, market expansion and debt reduction". Basically, money that was previously being paid to preferred shareholders will now be reinvested to grow the business. Since the preferred stock was converted in January an investor today will not be impacted by the dilution of the conversion, and will only benefit from the cash reinvestment into the business going forward. Additionally, Media Sciences announced it had raised $1.25 million from a private investor group, Richard L. Scott Investments, on June 30, 2004. This investment has allowed the Company to pay down $695,000 of debt and $500,000 on its credit facility resulting in no long term debt.
Financials
Based on Media Sciences¡¦ competitive positioning, market dynamics, and roll-out of INKlusive program, I believe the Company can easily grow EBITDA 15%+ organically long-term.
FY2005E (ending 6/05)
Revs 20.600 Note: Assumes 20% revenue growth
Op Income 2.700 Note: Assumes margins return to 13.1% level
+ D&A .832 Note: in-line with 2004 rate.
= EBITDA 3.531 Note: 5.1x Enterprise value of $18.3 million
I believe the intrinsic value of Media Sciences¡¦ equity is at least $2.50-$3.00 per share. This is based on an enterprise value/EBITDA multiples of 7-8x over my projected FY05 EBITDA of approximately $3.5 million. Many of the printer OEMs trade for higher multiples. I would argue that the pure "blade" business should trade higher than these multiples, but for the sake of conservatism, I will use the 7-8x multiple range. XRX, LXM, and other printer manufacturers trade around 10X forward EBITDA. GFX¡¦s size alone would certainly not warrant this type of multiple, but it¡¦s worth noting that the company is capturing a more profitable portion of the value chain, and has a higher growth rate. Alternatively, at a P/E if 15-18x the shares today are worth ~ $2.50-3.00.
Other Recent Developments that will add to the Company¡¦s sustainable cash flow
„Ï The Company has embarked on an aggressive program to expand its product offering for other branded printers. 11 of the Company¡¦s 25 total products (44%) started shipping since April 2004 (6 since April 2004, 5 since August 2004). I expect the Company to make similar announcements in the future for other OEMs.
„Ï In December 2003, the Company announced that it signed a distribution agreement with United Stationers, the largest broad line wholesale distributor of business products in North America.
„Ï Media Sciences has significant exposure to Xerox and its installed base of printers. At the end of 2000, Xerox teetered on the brink of bankruptcy. Xerox has been successful at regaining market share to make up for the decimation of its installed base over the past two-three years. Since this problem has been erased, greater equipment placements will increase the total probable market opportunity for Media Sciences.
„Ï The Company recently paid off some high interest loans from officers and executives. Some loans were carrying interest rates as high as 20-23%. Although it is unfortunate that the Company would enter into such arrangements for fear of the appearance of impropriety, this is in the past and management is committed to using a new $3 million line of credit more judiciously. The new equity investor (Richard L. Scott) appears to be much more ¡§shareholder friendly¡¨ and is the primary reason for ceasing these extraordinary loans. In connection with the offering, he received a board seat and now owns approximately 1.8 millions shares or 18.5% of the outstanding shares. With his oversight, the Company appears 1x1 aligned with our best interest.
Risks
The largest risk facing the Company is potential competition. However, I would point out that the Company is (1) the leader in the office color printer consumable space, (2) technological barriers from existing OEM patents requires future generic competitors to overcome highly technical design and manufacturing hurdles, and (3) the aggressive roll-out of INKlusive is contractually obligating customers to purchase Media Sciences¡¦ products.
There is a slight execution risk as the company mentioned at a recent conference that the Company is currently looking for additional manufacturing and warehousing facilities to solve impending capacity constraints. This was also mentioned in their most recent filing, but I don¡¦t think this is a huge operating risk.
Media Sciences competes primarily with the consumable products offered by printer manufacturers, or OEMs. These OEMs use patents and engineering tactics as technological barriers to entry. However, the Company has assembled a sophisticated engineering team to overcome these obstacles. For example, the Company introduced its first generic solid ink sticks in 1999 for the Tektronix line of printers. The Company has been able to successfully evade patent infringement since then, and continues to supply customers with ink sticks for multiple Tektronix models.
Catalyst
Short-term
Accelerating revenue and EPS growth.
Recent launch of seven new product lines.
Future announcements for new products on other OEM printers.
Long-term
Continued free cash flow generation
EBITDA growth of 20%+
Continued execution of business plan and overall growth of color printer installed based