Description

Excluding cash, RIMG’s ROTC has exceeded 90% in each of the last five years and the stock is trading at 13.3x 2008 EPS (using a heavily handicapped EPS estimate).

Background

Rimage (RIMG) is a leading provider of CD / DVD publishing systems.  On the surface, RIMG appears to be one of many companies producing disc duplicators, machines that create many copies of a “Master” disc.  Duplicators are commodity products that require little engineering, and these vendors compete primarily on the basis of price.  RIMG’s equipment can be used as a duplicator, but it is more often used like a network printer.  A RIMG system receives many heterogeneous data streams and uses them to produce individual or small batches of discs, each of which may have custom content and a custom, high quality label.  The technological requirements to do this are much higher than for simple duplication, and RIMG dominates this niche.  RIMG’s equipment is used in production environments where reliability is paramount, and it is often incorporated into 3^rd Party systems, which requires considerable systems integration work and a global support infrastructure.  Only two other companies produce this type of equipment (Primera and Microtech), and both of them lack the combination of technology, global support, OEM relationships, and scale to effectively address the high-end of the disc publishing market.  RIMG generates revenue from the sale of its equipment as well as the associated consumable supplies and maintenance contracts.  (2006 revenue was 54% equipment sales, 41% consumable sales, and 5% maintenance contracts.)

End Markets

The volume and variety of digital information continues to grow, and much of this data is shared or stored on optical media (i.e. CD / DVD).  RIMG’s equipment is used in a wide variety of applications to automate the production of discs with custom content and professional quality labels.  These systems are used in numerous general business applications including financial services and video production.  According to RIMG’s 2006 annual report, the company’s customers included “all major US banks, plus such large payroll processing firms as ADP and Ceridian.”  In check and payroll processing applications, RIMG’s systems have largely replaced paper and microfilm. 

Another application is medical imaging.  In radiography, digital output is replacing film as each generation of radiography equipment captures more information in order create higher resolution images.  Digital output is also faster and less expensive than film.  GE, Philips, Siemens, and Agfa have incorporated RIMG equipment into their Picture Archiving Systems (PACS) so they can provide a digital copy of the images to referring physicians and patients.  Because some of the newer modalities generate so much data, it is possible that RIMG equipment could some day be incorporated into individual machines.  RIMG believes it has 80-90% marketshare in medical applications. 

It’s main competitor in the medical market is Primera.  While Primera’s systems are not robust enough to meet the demands of large hospitals and imaging centers, they are adequate for small to medium hospitals where the requirements are lower.  After getting a better understanding of its customers needs, RIMG recently launched new products for this market that it hopes will allow it to better compete for these smaller customers.  

RIMG’s highest profile application is at retailers.  Fuji, Kodak, Agfa, and Noritsu have integrated RIMG’s equipment into their photo processing systems so photo labs can more easily produce disc copies of the pictures they are printing.  In the past, discs have been manually produced on simple CD drives such as those found in most PC’s.  Besides being manual, this process was also complicated by the fact that lab traffic is not linear and tends to spike during periods such as lunch-time and on the weekends.  The resulting discs also had generic surfaces, making it trickier to keep the right disc with the associated prints.  These factors made discs unpopular with the photo clerks responsible for managing the labs’ workflow.  (In the past, some clerks at busy labs wouldn’t ask customers if they were interested in a disc while others would even discourage customers from ordering one.)  RIMG’s equipment addresses these issues since the disc production is automated, and each disc has thumbnail pictures of the images contained on the disc.  At some installations where RIMG has been retrofitted into existing photo processing equipment, the “take rate” on discs has increased 3-5x. 

While early users of digital cameras printed images at home and stored the associated files on their hard drive, the photo industry has seen a shift back towards printing through the retail channel.  This has occurred as users have discovered that retail printing is much faster and cheaper than printing at home, and the resulting prints are often of higher quality.  This migration has also occurred as digital photography has spread among less tech savvy users who are more comfortable with having someone else print their pictures and create the digital backup copy.

RIMG has been tight lipped about retailer’s orders of its equipment.  Over the last few years, the company has formally announced a handful of large orders in order to ensure regulatory compliance (i.e. Reg. FD), including a 9MM order from WMT in 2005.  In 2Q07, RIMG announced an 8MM order from WMT that it described as part of an ongoing deployment at WMT.  (RIMG refuses to formally confirm that WMT was the source of these orders, but store visits in 2006 made it obvious that WMT was the big customer.)  In 2Q07, RIMG also announced a 6.5MM order from a different retailer; this order was for a storewide rollout.  While RIMG’s retail revenue is dominated by a few Tier 1 retailers, a total of 5-6 retailers have piloted RIMG systems and chosen to deploy them more broadly throughout their store bases.  In 2006, RIMG’s retail installed base increased 67% to 2,500 units.  By 3Q07, the installed base should exceed 3,000 units.  Management believes there is considerable opportunity for additional retail installations and in the 1Q07 earnings release, RIMG’s CEO said that retail application should be a growth driver over the next “several years.”  More importantly, RIMG has just begun to enjoy the consumables revenue stream from these systems.  Between additional deployments and higher utilization within the installed base, there is the potential for RIMG’s retail consumable revenue to increase as much as 4x.  RIMG faces no competition in this vertical. 

In the past, photography has been the primary retail application for RIMG’s equipment, but some national chains have also tested the same equipment for publishing software, music, and videos on demand.  This can be done on an ad-hoc basis (i.e. a catalogue of songs or titles available on-demand) or to avoid out-of-stock situations on new releases.  (When a new movie is released, 25% of retail outlets run out of stock within the first two days.)  Offering a catalogue of titles would allow brick-and-mortar retailers to participate in “the long tail.”   

A couple of developments must occur before DVD’s could be broadly published on-demand.  The first is an upcoming decision by an industry group that would allow videos to be distributed in this manner.  The second is the build out of the infrastructure to link the content’s source to RIMG’s equipment.  Some firms have already begun to build this infrastructure in anticipation of the upcoming industry group’s decision.  Downloading videos over the internet currently results in a major decrease in image quality.  Consequently, retailers will probably remain the primary distribution channel for purchased DVD’s until the last mile is crossed. 

Sales through RIMG’s “channel” of VAD’s and VAR’s are roughly 55% of total sales and include medical sales into existing radiology systems.  The remaining 45% of RIMG’s sales come from retailers and medical OEM’s.

Barriers to Entry

While RIMG has a couple of products that address the lower end of the market, it competes best in demanding applications where reliability and quality are paramount.  A photo lab at a retailer, for example, operates on tight schedules and produces at high volumes during peak periods.  In this setting, the disc production equipment must be extremely reliable, a characteristic that RIMG is known for.  I spoke to a small video production company who described their RIMG system as “a tank.”  This user was also impressed by the elegance of RIMG’s robotics.  I also spoke with a duplicator salesman who confirmed that RIMG dominates the high end of the market where performance is more important than price. 

In the retail and medical fields, RIMG enjoys major first mover advantages since it has already undergone the long and difficult process of integrating into the OEM’s equipment.  In these markets, RIMG also benefits from OEM’s needs for a global support infrastructure which few of its competitors can provide.  Though theoretically possible, I think it is highly unlikely that another company would be able to duplicate these OEM relationships.  The disc publishing equipment is a small part of an OEM’s overall system, and the systems integration efforts entail considerable effort on the part of the OEM.  It’s thus unlikely that an OEM would elect to integrate equipment from one of RIMG’s competitors, especially since RIMG’s own equipment already performs so well. 

Financial Profile & Performance

RIMG has a bullet proof balance sheet with no debt, hardly any long-term liabilities, and $8.21 per share of cash.  The company has very respectable returns, with ROTC in the mid-teens over the last five years (including cash in the capital base).  Excluding cash, ROTC was over 90% in each of the last five years.

In 2004 and especially 2005, RIMG enjoyed some large orders from retailers that caused its revenue growth rate to nearly double to +30%.  This created grow-over challenges, and revenue growth slowed to 8% in 2006.  Non-retail-related revenue grew 15% in 2006.  (RIMG provides end-market sales information that is incomplete at best, but crude estimates suggest that the non-retail business has been growing in at least the mid-teens over the last three years.)

In the past, RIMG sold primarily through VAD’s and VAR’s.  While this was an effective distribution method, it left RIMG surprisingly ignorant of its end users’ needs.  In order to rectify this and also determine the long-term outlook for optical media, management commissioned a large consulting project in 2005.  This study spilled into 2006, and as it was wrapping up, the company began an ERP implementation which continued the string of extra expenses through 2006.  Management undertook this ERP implementation to replace the company’s antiquated system (which was over ten years old) and to prepare for anticipated future growth.  These two events were buried in SG&A and made it appear that RIMG’s operating margin was shrinking.  Without these expenses, profitability was actually improving. 

1H07 has had a number of surprising developments from financial perspective.  The first is that RIMG’s “recurring revenue” (consumables and maintenance) decelerated dramatically.  After growing roughly 30% in 2006 and 47% in 4Q06, recurring revenues grew only 2% in 1Q07 and 5% in 2Q07.  This recurring revenue represents nearly half of the business, so this led to a major deceleration in total sales.  The first problem was that the inventory of consumables in RIMG’s VAD/VAR channel was bloated coming into 2007.  RIMG offers rebates to its distributors who meet certain order levels by YE.  While distributors customarily “load up” at YE in order to attain these rebates, they overshot in 2006.  (RIMG is considering changing this program to tie rebates to sales to end users.)  It also appears that one of RIMG’s retail customers tried to source optical media from a third party in 1H07.  Because third party media is less expensive, this is an attractive option for purchasing agents, but third party media often lacks the tolerances required by RIMG’s robotics and thus leads to equipment failure.  This is why most retailers choose to buy media from RIMG.  On the 2Q07 call, management said that the channel’s inventory issues had been resolved and that consumable sales would begin to build in 3Q07. 

The second and more significant surprise was a major increase in SG&A expense which increased 41% Yr./Yr. (18% seq.) in 2Q07.  (I have adjusted SG&A to treat RIMG’s ERP implementation as non-recurring.)  This was largely due to aggressive investments in RIMG’s S&M resources, though there were some one time costs such as severance as well.  Management had previously communicated their decision to invest in S&M, but they had not described the magnitude of this investment.

RIMG’s previous marketing strategy was developed 10 years ago by a gentleman who recently retired.  Senior management brought in a new VP of S&M who began asking questions that the company had never been asked before.  This new VP, for example,  asked how many of the “Global 100” companies used RIMG equipment.  Senior management said that they thought most of RIMG’s customers were mom and pop operations, and few of the “Global 100” were likely to be using RIMG systems.  An internal study, however, determined that 66 of the “Global 100” had bought RIMG equipment, though most of them had only purchased one or two systems.    Not only was this VP identifying new opportunities, but many of them were bigger than the ones that RIMG was already pursuing.  Consequently, management has chosen to aggressively build the company’s S&M capabilities in the US and abroad even though this is creating a major drag to the company’s short term earnings.  While it is too early to estimate the potential benefits of these investments, it appears that RIMG may have discovered underserved markets that it is uniquely positioned to serve.

Incidentally, in 2Q07, after consistently saying that they were not interested in a dividend or a share repurchase, management announced that the board had authorized a share repurchase equivalent to roughly 5% of RIMG’s diluted shares out.  I think it’s possible that they recognized how their S&M investments would render previous EPS estimates too aggressive and create a significant repurchase opportunity. 

Longer term, I expect RIMG’s stock to perform well as the company continues to execute within its niche, which is growing.  There is a general trend for information to be stored digitally and much of this is stored and shared on discs.  One of the reasons management invested in an ERP is because they believe RIMG will see continued growth as its expands in its existing markets.  Management mentioned that they believe the general business market and RIMG’s international business are underpentrated.  Over time, they’d like to grow their international sales to 50% of the business, up from about 33% today. 

Risks

RIMG is exclusively focused on optical media which generally competes with other forms of digital storage such as magnetic tape, hard disk drives and flash memory.  Each of these mediums is best suited for certain applications based on their relative cost, weight, durability, portability and security.  CD / DVD’s are typically used in applications that require very low cost, portability, and sometimes security.  (It’s easier to safeguard the data shared through a few CD’s than data held on a storage server that can be hacked into.)

A couple of developments could significantly diminish CD’s advantages over hard drives.  The first of these would be a proliferation of bandwidth (including in the last mile) which would improve the relative competitiveness of storage servers and their associated networks.   Bandwidth limitations currently make it cumbersome or unfeasible to distribute large files over the internet.  The second development would be a dramatic and sustainable improvement in the security of the internet.  This too would improve storage server’s relative position since it would blunt CD’s security advantage. 

Microtech is the only other company in the CD / DVD publishing space that offers high-end products like RIMG’s.  RIMG, however, rarely runs into Microtech, presumably because Microtech is a tiny company (one tenth of RIMG’s size at most).  Microtech’s size disadvantage is especially significant among large customers using this equipment for mission critical applications.  Such customers desire the assurance that their equipment vendor will be around to support them for years to come.

Valuation & Return Expectations

While RIMG’s business has outstanding economics, the revenue stream is lumpy and management lacks near-term revenue visibility.  (Management thus offers only one quarter of guidance at a time.)  Going forward, the company has a couple of factors that should improve revenue and earnings growth.  The first will be the recovery in RIMG’s consumables revenue that is expected to begin in 3Q07.  The second is the eventual fruit of RIMG’s investments in S&M, though these are hard to quantify, and I’m not incorporating them into my estimates at this time.  I am conservatively estimating EPS to be $1.25 (ex. Non-Rec.) and $1.38 for 2007 and 2008 respectively.  Results could end up being much better than this, but I’m being conservative since the business is lumpy and the last two quarters have been disappointing from a financial perspective.  (I had originally estimated $1.76 and $2.22 for 2007 and 2008, but that was before the consumables revenue decelerated dramatically and management throttled S&M far more than I had anticipated.)  These EPS estimates include $0.20 and $0.21 of interest income, and the firm has $8.21 of cash.  After netting out the cash and interest income, at $23.85, the P/E is 14.8 and 13.3x for 2007 and 2008 respectively after netting out the cash and interest income.   (At $23.85, RIMG is trading at 12.1x 2006 EPS, ex. Non-Rec.)  RIMG's capital requirements are low, so EPS is a very good proxy for FCF.

Given the degree to which I’ve handicapped my estimates, the stock is at a low valuation and presents a low-risk opportunity to buy a business that dominates its niche and serves a growing market.  The business has good underlying growth drivers, but there is also the possibility that the new VP of S&M has indeed identified large new opportunities and that the company will successfully exploit them.  These represent a source of considerable upside since they will lead to a revenue acceleration. 

Catalyst