Description

While not the most exciting business under the sun, being the global leader in mailing meters sure does generate a ton of cash. Pitney Bowes (PBI) has over 65% market share in global mailing meters and will generate $550 Million in Free Cash Flow in 2002, (7.1% FCF yield).

The Company will earn $2.37 in EPS this year and is one of the few companies out there to meet full year earnings guidance given at the beginning of the prior year. PBI shares currently trade at 14x earnings with a 3.6% dividend yield.

The Company’s core business is leasing meters to stamp business origination mail. Pitney estimates that in the US there are over 200 Billion pieces of mail annually and that 80 Billion are Business Origination. The remainder is split between Junk/Marketing mail (80 Billion), Consumer (20 Billion) and Other (20 Billion). While mailing volumes in the US are down slightly this is mostly in the area of Consumer (email substitution) and Junk Mail (economy related), the Business Origination segment has been flat and this is where PBI plays, (68% of revenues are from the Global Mailing segment). The Company also participates in the mailroom outsourcing business at 28% of revenues and has a capital services arm representing 4% of revenues.

Margins and financial returns are healthy and what you might expect from a near monopoly - gross margins near 60% and operating margins over 20%. Return on equity has averaged 37% over the past 5-years helped by a very low level of shareholders equity ($918M). Gross margins should trend downwards over the next 3-5 years as the company grows its outsourcing business however, operating margins will not decline as rapidly due to the nature of outsourcing (high COGS, low SG&A).

Shares have been hurt this year by ongoing concerns about PBI’s large asset leasing business that had exposure to both USAir and United (8 planes, all 737-300’s). The Company has stopped receiving payments from USAir and has taken a $100 Million charge for all 8 planes. Total airline exposure is about $500 Million across 31 planes and 9 carriers.

The catalyst for shares is the product transition cycle from electronic to digital meters that has been mandated by the US Post Office. The last meter transition from manual meters to electronic meters helped grow revenues and earnings and the stock doubled from early ’97 to mid ’98. In addition, the Company stands to benefit from a closer working relationship between PBI and the USPS going forward under the recently announced Postal Reform Act.

As an example of how Pitney can benefit from the Postal Reform Act consider that the USPS pays $36 an hour to an employee doing sorting work. The same work could be outsourced to one of Pitney’s sorting houses and done at $10 an hour. It is natural for the USPS and PBI to work together as Pitney sells more than $15 Billion in annual postage on behalf of the Post Office.

The product transition is helpful to margins and sales. Digital meters contain more industry standard components and manufacturing will be outsourced increasing margins. In addition, the meter has an inkjet print head that needs to be replaced and carry’s high supply type margins. Digital meters also offer security and tracking features which PBI charges for on a value added services basis. The take rate on value added services is over 20% and double managements expectations.

Since the average lease is 36-months the customer base turns every 3-years offering the opportunity for upsell of the new product line to over 20% of PBI’s revenue base. Even muted success selling the new value added services (upgrading to digital meters is mandatory by 2006) should lead to revenue and earnings growth going forward.

A further catalyst will be the winding down of the capital services business that many investors find opaque. This should generate an additional $400 Million in cash next year but cost about $.10 in earnings (already discounted in 2003 sell-side estimates). As a quick check on quality of earnings, PBI’s Net Income and Free Cash Flow are almost equivalent over the past 4 years ($2.4 Billion in cumulative Free Cash Flow since 1998 versus $2.3 Billion in Net Income).

Pitney’s uses of cash are three fold: dividends/share repurchases, acquisitions and internal investment. In 2003 the company will invest in their SAP roll-out and most likely do small acquisitions around their core mailing franchise. PBI shares pay $1.18 in dividends and PBI has brought their share count down from over 300 Million in 1996 to 240 Million today.

Catalyst

Transition from electronic to digital meters driving revenue growth and earnings, mail reform act announcement in June of ’03 and double taxation of dividends relief should drive earnings and provide multiple expansion.