Description

NEOPOST


I believe there are very few businesses that can match Neopost’s (the “Company”) ability to generate (and grow) free cash flow. Neopost’s business is characterized by numerous attractive characteristics, including: extremely high barriers to entry; strong pricing power in a global duopoly; a high level of recurring revenues; and the ability to reinvest its earnings back into its core business with a high return on investment. The predictability of their earnings is outstanding and the Company is well positioned to capitalize on several growth drivers over the next few years.

Business Description

Neopost is a leading player in mailing equipment. The industry is a virtual duopoly, with Pitney Bowes (NYSE: PBI) owning 62% of the market and Neopost accounting for 26% market share. The remaining 12% share belonging to other market participants is rapidly shrinking as technological advancement and economies of scale continue to drive competitors to the brink of bankruptcy.

Neopost’s business is identical to that of Pitney Bowes’ Global Mailing Division, which is described in their 10-K as the “rental of postage meters and the sale, rental and financing of mailing equipment, including mail finishing and software-based mail creation equipment.” What makes the business intriguing is that most governments of developed countries do not allow companies to directly own various components of the mailing meters (or “franking machines”), providing an opportunity for Neopost and Pitney Bowes to lease equipment to its customers at attractive prices. In a meeting with Neopost’s Chairman and CEO, Jean-Paul Villot, he provided interesting insight into Neopost’s business, saying he likes to think of his business as being comparable to the US Treasury -- “We print money.” Mailing meters account for 70% of sales, with the remaining 30% generated by letter folder/inserter machines and parcel shipping systems. Approximately 60% of Neopost’s revenues are recurring in nature, with the remaining 40% being derived from equipment sales.

While the mailing business itself does not, on the surface, make one want to jump out of his/her seat, there are numerous things that make the business attractive:

· By automating the postage process, mailing meters, do, in essence, “print money,” as Mr. Villot stated. Neopost’s healthy profitability results largely from high barriers to entry in the mailing meter market. It is extremely difficult for potential newcomers to obtain the necessary authorization to produce meters from a nation’s post office. (Why would the US Postal Service want to deal with 5 different people when 2 are sufficient?) Additionally, most governments do not allow users of mailing meters to own their equipment, allowing Neopost to rent machines to its customers on 4-6 year contracts. Such dynamics result is the industry being an “installed base” business. Leasing and maintenance contracts result in high levels of recurring revenues. It is very difficult for a competitor, especially smaller players, to gain market share -- which leads to the next point.

· The business is one that lends itself well to economies of scale. Believe it or not, there is quite a rapid rate of change in mailing technology. Because governmental agencies worry about security and fraud in postage and mailing, (as the US Treasury does with counterfeiting), most countries issue “decertifications” every 4-5 years. Under such decrees, various components of the system must be upgraded to comply with new specifications. This leads to a natural replacement cycle for Neopost and Pitney Bowes. Furthermore, the growing complexity of mailing meters (including the ability to trace ordinary mail until delivery, being able to automate the download of software when postage rate changes occur, buying additional postage credits through the franking machine, etc.) has raised the technological bar. Neopost purchased Ascom Hasler, a struggling competitor, in 2002 due to its inability to absorb rising R&D costs. According to Neopost’s management team, Francotyp Postalia, the last remaining significant market participant outside of Neopost and Pitney Bowes, faces similar problems. Interestingly, Francotyp Postalia is the only company outside of Pitney Bowes and Neopost to hold more than 50% of the installed base of any country (Germany). Germany’s government has issued a decertification in late-2004, meaning a majority of the installed base will be up for grabs. This presents a huge opportunity for Neopost as Francotyp Postalia has no digital products to compete and will likely lose much of their installed base. These business dynamics have unintentionally led to a situation with duopoly economics. Interviews with both Pitney Bowes and Neopost management teams have given me strong comfort that the two companies will NOT compete on price. Such strategy results in high margins as the industry participants hold pricing power given the low bargaining power of its customers. Thus, Neopost prices their machines to produce 70% gross margins and its leasing contracts to yield a credit-card-like 18% cost of financing. The default rate of Neopost’s leasing contracts has never exceeded 1%.

So why not own Pitney Bowes?

Fair question. Given that Pitney Bowes is several times larger than Neopost, why not own the gorilla? I believe there are a number of reasons Neopost represents a better investment than Pitney Bowes.

· Neopost will be the beneficiary of continued consolidation. As stated in Neopost’s 2002 Annual Report, “Two years ago, our sector entered a consolidation phase, in which we have been one of the main players. This process is not yet complete, and we intend to play a greater role in it.” I believe Neopost’s acquisition of Ascom Hasler in 2002, which tripled their presence in North America, was an incredible acquisition for Neopost – both strategically and economically. Ascom Hasler needed to be sold because it could not compete with Neopost and Pitney Bowes and its parent company needed liquidity. Neopost was the only logical buyer for the business, as Pitney Bowes would have faced serious anti-trust issues. Pitney Bowes already controls 80% of the US market for franking machines. In January 2002, Neopost announced their intention to acquire Ascom Hasler for €217 million. Ascom Hasler was only mildly profitable because of the reasons mentioned above. Ascom Hasler generated revenues of €207 million in 2001. Neopost was basically able to cease all R&D at Hasler and cut manufacturing and distribution costs. The synergies of folding the business into Neopost are enormous. Denis Thiery, Chief Financial Officer of Neopost believes that by the end of 2004, Ascom Hasler’s EBIT margins will be brought in-line with that of Neopost, which he hopes will be around 22%. Neopost’s long-term profitability goal is to rival that of Pitney Bowes, which enjoys approximately 30% EBIT margins in its Global Mailing Division. As previously mentioned, Francotyp Postalia is the last remaining competitor with significant share. In early 2001, Neopost also acquired Stielow, a German business that participates in the domestic mailing equipment market. Neopost now has a well-established presence in Germany to capitalize on the country’s 2004 decertification and Francotyp Postalia failure to compete. It is my belief that management will either acquire some of the assets of Francotyp Postalia inexpensively or simply take share in the next upgrade cycle.

· Ability to re-deploy its cash flow back into its core business. The Ascom Hasler acquisition is a great example of why Neopost has a lot of room to grow in its core business of mailing solutions – a business that they believe they can continue to invest in and achieve a 20%+ return on investment over the next several years. The Company will also deploy the cash the business generates into acquiring distributors throughout its network, both in Europe and North America. Neopost currently owns 40% of its dealer network. By contrast, Pitney Bowes owns 60% of its dealer network. Owning dealerships makes sense in areas where there is density among the installed base. Again, being a business that benefits from economies of scale, Neopost’s management indicated they will buy-in their dealer network to the extent they can achieve 20%+ annual returns on their investment. Management has indicated that the dealer network captures “a significant share of the value chain.” When pushed to give an example, Mr. Villot made reference to an acquisition of a dealer network in Italy with approximately €1.6 million in annual sales. It was “run like a family business” and nominally profitable. The business was purchased for approximately 0.75x revenues and once Neopost took over the operations, sales increased to approximately €8.0 million the next year with EBIT margins of approximately 20%. Neopost continues to gain market share vis-à-vis Pitney Bowes, both through organic growth and value-added acquisitions. By contrast, Pitney Bowes, which faces anti-trust issues if it takes too much more market share, has very few alternatives to re-invest its cash flow. As such, Pitney has moved into businesses with less attractive returns, such as investments in commercial aircraft leasing (for which it took a whopping $213 million write down in 2002) and reprographics/document outsourcing businesses. Pitney Bowes has taken an additional $96.5 million in charges in the first three quarters of 2003. Providing another data point, the last mailing business regulators allowed Pitney Bowes to buy was Neopost’s French competitor, Secap, a subsidiary of publicly traded Fimalac. (Neopost still owns 65% of the French market.) Despite the absence of another bidder for the business, Pitney Bowes paid 2.14x revenues and over 13x EBIT for Secap in 2001. While I find it very encouraging that Pitney Bowes believes it can still generate an attractive return on its investment after paying such multiples for Secap, I prefer to invest in a management team with a bit more purchase discipline.

· High quality earnings. Neopost’s free cash flow conversion is excellent. In fact, the business has been LBO’d twice in the past 15 years and Mr. Villot confessed to considering another management buyout early in 2003 when the Company’s stock fell below €30. With guidance from management, I believe Neopost will generate free cash flow in excess of net income in both 2003 and 2004. Neopost’s cash generation is consistent and predictable enough to make a major acquisition of a competitor, buy-in several distributors in accretive deals, and institute the Company’s first ever dividend of €1.00/share, all within a 12 month time frame. While Neopost continues to gain market share and chip away at Pitney Bowes dominant position, in 2002, Pitney Bowes placed 33% of its EBIT into its under-funded pension plan, on top of the previously mentioned write-offs, which represented another 21% of EBIT.


Valuation/Financials

Neopost is trading at approximately 13x my 2005 EPS estimate and 11x my 2006 estimates. EBIT will grow at double-digit rates over the next few years and the FREE CASH FLOW CONVERSION IS CLEAN AND CONSISTENT.

According to Neopost’s management, the mailing equipment business grows at a long-term rate in excess of 5%. While the installed base of meters tends to mirror economic (GDP) growth, average selling price has been increasing nicely with the development of new digital technologies and value-added services. Additionally, a more rapid rate of technological change has increased the frequency of global decertifications, thus, decreasing the length of a mailing meter’s useful life. Combined with significantly lower cost Asian manufacturing (China will manufacture 40% of Neopost’s equipment within 12 months), the industry enjoys consistent growth with a decreasing cost structure. The results can be seen in Neopost’s operating margins:

1996 1997 1998 1999 2000 2001 2002* H1 2003

16.7% 18.6% 19.6% 20.6% 21.0% 21.5% 19.2% 20.3%
* 2002 reflects the acquisition of Ascom Hasler, which temporarily depressed operating margins.

Additionally, Neopost has been able to increase its revenues more quickly than it’s competitors by taking market share. While Pitney Bowes does enjoy 29.7% EBIT margins from their Global Mailing Division (in 2002), cost efficiencies have been maximized and revenue growth remains challenging. Pitney Bowes has grown its revenues by 6% and 1% in 2002 and 2001, respectively, while divisional EBIT has grown by 4% and 2% in those same years.



FY 2003 FY 2004 FY 2005 FY 2006
Sales € 731 € 741 € 790 € 841
Organic Sales Growth 3.5% 6.5% 6.5%
FX Impact -2.0% 0.0% 0.0%
Total Sales Growth 1.4% 6.5% 6.5%


EBIT € 154 € 163 € 186 € 210
EBIT Margin 21.0% 22.0% 23.5% 25.0%
% EBIT Growth 6.3% 13.8% 13.3%

Interest Expense-21.5 -€ 16.83 -€ 11.26

PreTax € 142 € 169 € 199

Taxes -48.150707-57.37183-67.655108
34.0% 34.0% 34.0%

Net Income (Pre Goodwill) € 89 € 93 € 111 € 131

EPS 2.9372937 3.0847861 3.6755395 4.33434

EPS Growth 5.0% 19.2% 17.9%
FCF € 93 € 111 € 131


· The United States Postal Service is working with Pitney Bowes and Neopost to encourage the technological upgrade of the installed base of mailing meters in the US to enhance productivity. According to Pitney Bowes 2002 10-K, the Company has “adopted a formal plan to transition to the next generation of networked mailing technology. The information capture and exchange, made possible by advanced technology, turns the postage meter into an ‘intelligent’ terminal that networks the mailer to postal and carrier information and systems. This two-way information architecture, in turn, enables convenient access to and delivery of value-added services such as tracking, delivery confirmation and rate information. The adoption of this plan was facilitated by our expanded access to technology and our ability to move to networked products combined with our expectations that the US and postal services around the world will continue to encourage the migration of mailing systems to networked digital technologies.” Such technologies and value-added services have significantly increased the leasing rates of mailing meters in the US. Neopost estimates 80% of the US installed base will be upgraded/renewed by the end of 2008. This is the first such upgrade cycle Neopost has been able to participate in with a more established presence in the US.

· I have excluded any earnings accretion from additional acquisitions. Additionally, management has hinted that synergies from Ascom Hasler will exceed their initial projections of €22 million.


I believe the predictable growth, high barriers to entry, strong profitability (20.3% EBIT margins and 26.1% ROE in the first half of 2003), and top-notch management team make Neopost a compelling investment. Given Neopost’s visibility and defensible business, I see no reason why the stock should not be valued at 14x conservative 2006 earnings of €5.00, or €70.00, by the end of 2005.

Investment Considerations

· Participation in a global duopoly (26% market share) with high barriers to entry
· 60% recurring revenues due to leasing and maintenance contracts
· High degree of profitability (20.3% EBIT Margin and 26.1% ROE in H1 2003)
· Natural upgrade cycles due to government issued decertifications
· Ability to re-invest into its core business at 20%+ rates of return on investment
· Future margin improvement through economies of scale and lower cost manufacturing
· Global mailing industry about to enter a growth period with two of Neopost’s top four markets (Germany and the UK) undergoing decertifications in 2004. 80% of the US market will need to be upgraded to digital technologies before 2008
· Strong free cash flow generation
· Longer term potential to penetrate emerging markets (Pitney Bowes and Neopost are working with lobbyists to open Chinese, Indian and Brazilian markets to private mailing equipment)
· Top notch management team who have exhibited excellent capital allocation

Risks / Considerations

· Secular shift away from traditional mailing. Obviously, alternatives, such as the Internet, e-mail and priority mailing services (FedEx) have decreased the amount of mail being processed. However, less mail volume itself does not affect Neopost’s profitability. Neopost’s revenues are dependent on the installed base of mailing meters. The installed base has grown consistently with GDP. Additionally, increased functionality has raised average selling prices considerably over the past few years. Should mail substitution continue to the point of actually decreasing the installed base of mailing meters in the future, Neopost’s business will be at risk. Countering such forces is the potential automation of the mailing systems of developing countries.
· Technological follower. Neopost participates in an R&D-intensive business characterized by numerous patents and significant intellectual property. Pitney Bowes is clearly the driver of new technologies, spending $141 million, or 3.2% of sales on research and development in 2002. Neopost tends to lag Pitney Bowes in research and development, spending less absolute dollars (€32.8 million in 2002) than its competitor. For example, Pitney Bowes displayed several mailing meters with dynamic weighing (the ability to rapidly meter mail of varying weights and postage requirements) at their Analyst Day in March 2003. Neopost did not incorporate such functionality until Q3 2003.
· Low level of insider ownership. As is typical of most European companies, management holds a nominal equity stake in the business. Senior management owns approximately 3% of the common stock.

Catalyst

· Participation in a global duopoly (26% market share) with high barriers to entry
· 60% recurring revenues due to leasing and maintenance contracts
· High degree of profitability (20.3% EBIT Margin and 26.1% ROE in H1 2003)
· Natural upgrade cycles due to government issued decertifications
· Ability to re-invest into its core business at 20%+ rates of return on investment
· Future margin improvement through economies of scale and lower cost manufacturing
· Global mailing industry about to enter a growth period with two of Neopost’s top four markets (Germany and the UK) undergoing decertifications in 2004. 80% of the US market will need to be upgraded to digital technologies before 2008
· Strong free cash flow generation
· Longer term potential to penetrate emerging markets (Pitney Bowes and Neopost are working with lobbyists to open Chinese, Indian and Brazilian markets to private mailing equipment)
· Top notch management team who have exhibited excellent capital allocation