The Business

As it stands now, about 87% of the business is traditional mail ($5bn market globally, according to the company), which constitutes franking machines (70% of 2011 revs) and folders/inserts/mail tracking. Revenue split by region is 40% US, 25% France, 12% UK, 7% Germany, 16% ROW.

Then the rest is Communicating & Shipping Solutions (CSS) which is tracking and tracing, some shipping solutions, lockers, data quality and a few other things.

Mail is obviously something without much top line growth – here are some charts from a recent UBS report to give you a sense:

So the second chart shows that US mail has been declining 2.1% per annum – actually stamped mail has been worse and franking is kind of a substitute for stamping, while advertising, which Neopost products are great for (you can do stuff like put together tailor-made mail shots fairly easily with their products), has seen only modest declines. All the same, it is not a growth business.

Industry structure is, in my view, highly attractive – consolidated, high barriers to entry, highly profitable, high cash generative.

There are already some good resources on the nature of the industry, but really what these machines allow you to do by printing postage is to effectively “print money” (see earlier writeup on the company on VIC). Result is that it is highly regulated:

ü  In many countries a business is not even allowed to own the machinery

ü  70% of 2012 revenues were recurring (maintenance and machine rentals

ü  Governments often require “decertification” of equipment and upgrades every few years to protect the integrity of the system

This type of industry requirement is ripe to be consolidated, and this is indeed what has happened, with the associated benefits:

ü  Pitney Bowes control 61% of the installed base, Neopost another 24%, Francotyp Postalia a further 10%

ü  So 85% of the market controlled by the top 2, 95% by the top three

ü  FP been loss making in 5 of the last 7 years, I think maybe due to lack of scale

ü  Customer base very diversified (Neopost has over 800,000 customers)

ü  Operating margin for Neopost for the mail business in excess of 25%

ü  Group enjoys low to mid teens ROIC

ü  Highly cash generative – group OCF less capex less intangible capex has averaged 120m in the last 5 years

ü  And this is with capex plus intangible capex 10m greater than D&A, on average

Neopost have actually enjoyed modest growth in mail – presentation material is a little frustrating as the “constant currency” growth they often refer to does not always break out the structure effects, but for example in Q412 they reported positive organic growth, and refer in the registration document to sustained market share gains.

This is borne out by a look through Pitney Bowes’ 10-K – page 16 shows their US revs declining 7% in 2011 and 2012, while group revenues in this vertical declined 4% in 2011, 7% in 2012.

Worth noting that PB reported operating margins in this vertical of 31% in 2011 and 30.8% in 2012, however. Indicates some of the resilience the industry had to top line declines, and also highlights the consolidated, profitable nature of the industry).

So the bulk of the business is low growth, but they have been taking market share, highly profitable, high returns on invested capital, high free cash flow (will get to that in more detail below).

Recent trends in that business are uninspiring but, I guess, mildly improving. At H112 stage US was -5.2% in constan currency, as the replacement cycle moderated and efforts to redeploy the sales force went a little more slowly than planned - that improved slightly in H212 to about flat performance; France was horrible in H112 at -9.3% as they lapped a contract win and some postal rate changes - they were still suffering those effects in H2, plus a quite depressed market, but the rate of decline (off a harder comp as well, moderated to -5.7%); UK has been growing low single digit and Germany mid to high single digit (UK and Germany combined about as big as France)

Rest of the business (small for now at  ~137m FY12 but 161m when you pro forma some deals they did mid-2012) is what they call more niche, adjacency markets – they break the markets up into three:

ü  Shipping

• Managing and tracking of parcels and letters
• Parcel lockers

ü  Data Quality

• Capturing customer data (acquired two companies – Sartori & Human Interface)
• Address management systems
• Mail handling optimisation

ü  Customer Communication Management

• Direct marketing applications
• Templates for bills & statements
• Embedding messages in statements
• Sounds dull but acquired GMC in 2012 – 42m sales +28% growth margin >10%

Each of these verticals they claim is a 1bn markets – stated goal is eventually to get to 15% share in each, so a 450m opportunity. Intermediate target is

Overall margin in growth areas is just over 12% but the fact that they are adjacent to the core business presumably implies that as they build scale, there should be synergies. Nonetheless, given group margins of mid 20s, the growth is going to be dilutive to the margin.

Financials

As stated, the growth has been fairly muted, but the very consolidated nature of the industry, high barriers to entry and lack of consolidation amongst customers has guaranteed high margins and good operating margins:

The cash conversion has also been very good, with cash from operations as a percentage of EBIT being pretty consistent around 80%:

Even with quite high capex “all in”, it has translated to very good free cash flow, which I think should be sustainable:

Intangibles capex I think should decrease as they are targeting >200m sales in the new businesses by 2014 and are already at 161m pro-forma – given they think these markets can generally grow double digit, they should not need to continue at the previous acquisition pace to get there.

That leaves free cash flow at about 137m, or 4.04/share. In 2012 they paid a 3.90/share dividend, and effectively committed on the Q4 conference call to maintaining that – so that is where the cash goes. That is an 8.6% dividend yield.

They claimed that any bolt on deals would be in the 10m-40m sales range and would not impact the dividend, which reassures me a bit, as one of the operation risks is obviously that they try to acquire growth with the returns not being obvious.

Net debt to EBITDA is about 2.4x as of 2012 y/e – so while the balance sheet is not fortress-like, they can theoretically even borrow to finance any more aggressive growth they wanted to do. And pay a 3.90/share dividend. Gross debt is about 960m and they pay less than 4% interest on that. No maturities for a couple of years.

In terms of the sales and EBIT numbers I am generating – I am assuming the core mail is flat in 2013 then -1% pa thereafter (guidance is >0%), while the new business gets a 17.5% structure benefit in 2013 along with 15% organic growth.

I have margins in the core mail business pretty much flat (actually very marginal declines). The key risk to mail which has been highlighted in one piece I read is that Neopost have been taking share from Pitney Bowes for years and that reverses – I think when you look at the state of PB’s balance sheet and the fact that Neopost have some new products recently coming to market – it is not that realistic to think that PB will suddenly start to go after them.

New business margins I have gradually rising to 14.6% in 2015 – management do not disclose the exact margin now beyond saying it is “over 12%”.

Value

For the low teens ROIC that that company generate, given the low growth, I think that just over 1.5x invested capital is justified. That implies about 53/share as a y/e 2015 target. Not very exciting on a 45.60 share price, but of course you clip a 3.90 dividend (all in cash from here on out) per annum, which bumps the IRR up to about 14%.

One potential issue that I have is that a 53/share target implies a P/E of just over 10x on my earnings estimates. That then creates a couple of follow on issues:

ü  Would you pay 10x given the perception of structurally challenged end markets (or more precisely if you buy it at 8.9x now, will someone buy it off you for 10.4x

ü  Numbers a touch below consensus

On the first point – yes it is an industry without very much growth, but all the same, very consolidated with good margins and returns. Historically the business has traded for between 6.5x (gulp) and 10.5x, so we would be hoping for some rerating.

On the second point, for instance in 2014 I am at 5.03 of earnings, consensus at 5.21 – consensus does have higher sales than me – that could be through some acquisitions, or it could be that they are a bit less pessimistic on the core business. To be fair, the business overall did report some organic growth in Q4, so initial signs may be that I am too pessimistic.

Holders

Largest holder is First Eagle Global – scion of that fund is Jean-Marie Eveillard, the famous European global investor (profiled in the imaginatively-titled recent book “The Value Investors”). His fund (SGENX US on bbg) has done annualised returns of about 6% over the last 5 years (94^th percentile, according to Bloomberg). Looking back through the interim reports, I think he got into it around 2009, so he is about flat on it so far.

Risks

• They overpay for acquisitions, particularly at the expense of cutting the dividend
• Pitney Bowes come back with a vengeance in the core business
• Stock just steadily derates as