Description

Schawk is the 800 lb. gorilla of the fragmented, but consolidating prepress services industry. A $17.93 stock price represents a good entry point as the company is still in the process of integrating the acquisition that got it “gorilla” status and further synergies should accrue to shareholders. In addition, a large, imminent offering of secondary shares will improve the company’s limited float and garner increased attention from sell side analysts. The company has a market cap of about $500M, EV of $675M and should do revenues, EBITDA and EPS of $660M, $105M, and $1.56 per share in 2006. We think the stock could reach $25 to $30 per share within the next 12 to 18 months. The company is run very well by the Schawk family, whose 60% ownership stake keeps their interests well-aligned with those of shareholders.

Company/Industry Overview:
Schawk operates in the $30 billion prepress services market – focusing on the $15 billion sub-market for consumer products packaging, advertisements and promotions. Prepress services cover the intermediate steps between the layout/design of the packaging or promotion and the actual printing. In the past, this mainly involved the production of the printing plates. In the digital age, Schawk’s work increasingly focuses on the creation of “digital plates” – essentially computer files that are customized for the specific press (model, age) on which the packaging will be printed. Schawk will ensure, for instance, that Coca-Cola red looks the same no matter in which country and on what press it is printed.

Schawk’s selling relationship is often directly with the consumer products companies who trust Schawk to be the custodian of their brands. They sell to about half the Fortune 100 and are one of the few companies to have both Pepsi and Coke as clients. The display of brand names, trademarks, and associated symbols and colors is extremely important to Schawk’s consumer products clients. Schawk personnel are often co-located onsite of some of the firm’s largest customers, further strengthening the relationships. These co-located offices are often the result of clients outsourcing their in-house prepress personnel to Schawk (see 11/17/2005 Nestle U.K. announcement) and often allow Schawk to negotiate multi-year contracts rather than bidding for work on a per-job basis.

Prepress companies typically get paid based on changes in packaging, not on volume. As a result, business drivers include regulation (serving sizes, trans fat) and consumer fads (low-carb, Atkins, “new and improved”), rather than overall consumer demand. The company claims that there is an anticyclical component to their business: consumer products companies become more promotional during downturns in consumer spending. While this will remain to be seen, Schawk will continue to benefit from the erosion of traditional advertising channels (such as newspapers and television), which heightens the importance of point of sale advertising and product packaging.

Competition:
Schawk’s main competitors – the only other companies with >$100M of revenues – are Southern Graphics (~$250M in revenues) and a division of casket and bronze memorials maker Matthews International (~$150M in revenues of a total of $600M). Matthews prepress division focuses more on corrugated packaging, which is less of a focus for Schawk. Southern Graphics (until recently a rounding error within Alcoa) was just acquired by Citigroup Venture Capital. Printing companies – especially the larger ones like Quebecor and R.R. Donnelley – have tried for some time to bundle prepress services along with printing and tend to be more competitive on lower cost jobs where quality is not the primary focus. Overall the market is split about half and half between printers and independent prepress firms (many of which are mom-and-pop operations).

Why the need for a middle man? Separating the prepress work from the printing gives purchasing leverage to the consumer products company over the printers. Typically about 90% of the spend is for printing, 5% is for design and the remaining 5% is for prepress. The client can move the print spend more freely if the digital assets reside with the prepress company “middleman.” Advertising agencies and consumer products companies view the prepress area a non-core, specialized skill-set that they have thus far been happy to outsource. This is particularly true in Schawk’s core area of prepress work for consumer products packaging and in store displays, where the prepress work is more complex due to the nature of applying print to the various packaging substrates.

The Seven Worldwide Acquisition:
On January 31, 2005, Schawk completed the acquisition of Seven Worldwide ($360M in revenues, $28M estimated EBITDA in 2004) from Kohlberg & Co. for total consideration of approximately $191M – $122M in cash and 4M shares of SGK common stock which was priced at $17.15. We have heard that Kohlberg requested there be a stock component to the deal.

Seven originally came into existence as Applied Graphics Technologies (AGT) after being IPO-ed from Mort Zuckerman’s Applied Printing in 1996. Debuting at about $130M in sales, AGT subsequently went on an acquisition binge spending over half a billion dollars on a number deals that grew revenues to close to $600M by 2000. AGT’s former Chairman and CEO, Fred Drasner, was also the co-owner of the Redskins and had numerous other jobs throughout the Zuckerman empire. It appears that AGT management may have focused more on doing the deals rather than integrating them.

The advertising recession and the popping of the internet bubble were unkind to AGT and pushed the firm into financial distress. In early 2003, AGT’s debt-holders sought a restructuring and approached Kohlberg, which ended up buying the business later that year for about $130M (85 cents per share for the equity and around 50 cents on the dollar for roughly $250M of debt). To turn around the businesses, Kohlberg tapped John Harris, a long-time EDS executive and prior AGT board member. Harris sold off some non-core assets and rebranded the disparate AGT factions under the Seven Worldwide name (which was acquired in AGT’s purchase of Wace plc in 1999 – for which they outbid Schawk). However, when Schawk bought out Kohlberg in January 2005, much of the restructuring of AGT’s binge acquisitions had yet to be completed. All in, Schawk paid about 7x trailing (pre-synergy) EBITDA for the opportunity to increase Seven’s low single digit operating margins to Schawk’s historical mid teens levels.

Just prior to the Seven acquisition, SGK paid $26.4M (0.7x sales) for UK-based Winnetts, which did approximately $38M of revenues, 90% of which were in Schawk’s core packaging segment. The Winnetts acquisition provided SGK with a strong presence in the UK and allowed them to realize significant synergies by integrating these with the UK operations of Seven Worldwide.

Another Rollup?
AGT’s failed rollup should not condemn the strategy. As the only global firm in the market, Schawk is able to manage client’s global prepress needs. This is an attractive proposition for consumer products giants who already trust Schawk as the custodian of their brands. According to management, they have already been winning business due to their newly global footprint. This should continue to provide them with an advantage over more local competitors as clients increasingly make sourcing decisions on a global basis.

Valuation:
$500M – Market Cap (P=$17.93 @11/21/05; SO = 28 including options)
$175M – Net Debt (as of 9/30/05; incl. restructuring reserves of ~$5M)
$675M – Enterprise Value

$83M – 2004 EBITDA (combined firms pre synergies)
$101M – 2005 “run-rate” EBITDA (9/30/05 quarter annualized)
$105M – 2006E EBITDA
$85M – 2006E EBITDA-less-Capex (maintenance is $15M)
$1.56 – 2006E EPS
$1.80 – 2006E FCF (D&A exceeds capex by about 8M in our model)

6.4x – EV/2006E EBITDA
7.9x – EV/2006E EBITDA-less-Capex
11.5x – P/2006E EPS
9.9x – P/2006E FCF

In their third quarter call management stated that they expect to improve operating margins at least 1% above the third quarter levels in 2006. This would add about $7M to operating profit and EBITDA assuming sales are unchanged. Our 2006 EBITDA estimate of $105M may prove conservative. The company is currently spending around $20M in annual capex, but this number should decline to about a $15 to $17M run rate (we assume $15 in our 2007 numbers), as the company completes the catch-up capex needed by AGT’s recently distressed operations.

During 2006, Schawk should be able to pay off about $50M of debt. Looking forward one year, SGK trades at 5.4x and 6.2x our 2007E EBITDA ($114M) and EBITDA-less-capex ($99M), respectively, assuming a projected 2006 year-end balance sheet.

Our medium term target range of $25 to $26 per share is based on a multiple of 10x 2006E EBITDA-less-Capex, which we think is reasonable for an industry leader in an acyclical business, with a long, largely-successful history of doing tuck-in acquisitions. Longer term, we think the stock could reach the low $30s if the company can show some organic growth in 2006 or 2007 and make progress on reducing its debt load. There are no publicly traded comps, but the recent purchase of Southern Graphics by Citigroup Venture Capital for $410M is in the ballpark of 1.5x sales, which would imply around $30 for SGK.

At prices in the $17s, we are also getting very close to the level where a “smart buyer” (Kohlberg) with tons of information opted to buy stock just about one year ago. We are now nearly one year on in the integration process, with much of the hard work of the consolidation behind us.

Risks/Why has the stock declined?
The stock is down significantly from the $26 high it reached over the summer. Earlier this year, the company stated on a call that they would provide an update on the synergies they hoped to achieve, but have opted not to do so. We believe this was in order to be sensitive to the large amount of head-cutting they have undertaken, in light of some minor issues with a New York-based union. There have also been some delays in completing the European integration of the acquired businesses as it is taking longer than expected to complete headcount reductions in the UK. Finally, the company has not guided for revenue growth in 2006. These issues do not concern us that much. On the guidance front, the company seems to be winning new business, but is being conservative as they wait to see what comes of the integration they are completing. We believe organic growth should materialize in 2007, if not sooner. Regarding the Euro integration delay, given sizeable task of merging three companies, one of which itself was a rollup, I can’t fault them too much, though they should have been aware of how long it would take to complete layoffs in the UK.

The Seven deal increases SGK’s exposure to advertising spending, as they did more circular and advertising insert work for retailers like Sears. Seven also came with a large L.A.-based movie business, which should benefit from an improved environment for new releases in 2006.

The Schawk family owns about 60% of the outstanding shares, significantly curtailing the float of this $500M market cap company. On a typical day, one would be fortunate to see more than 50,000 shares trade. However, this situation should be alleviated in the not too distant future, as the company has recently filed a registration statement for Kohlberg’s shares, which should lead to a secondary offering. The company pretty much views this as an IPO and will be very involved in marketing the stock to investors. They tell the story extremely well. The lure of underwriting fees, should increase research coverage, while the added float will give larger institutional buyers the opportunity to make meaningful investments.

One final point: there is a substantial short interest of about 1M shares (given that the actual float is probably no more than 7M). Much of the increase in short interest came about in July after the stock ran up to its highs and increased when the secondary was announced. Given the pretty limited trading volume, I’d hate to be short the stock when it comes time for the 1M shares to cover…

Catalyst

• Secondary offering of Kohlberg’s shares will increase float by about 50% and should lead to additional research coverage
• Further cost synergies from integration of Seven and Winnetts
• Ongoing opportunity to raise margins at Seven to historical Schawk levels
• Debt pay-down in 2006
• Further consolidation opportunities in the industry
• Possible buyout, if stock doesn’t go anywhere