Background

• Vistaprint is a battleground stock. Short sellers have historically been, and remain, very skeptical of the Vistaprint business model, and 27% of the float is shorted. The current bear case is predicated on the secular decline of print, market saturation, a failed European strategy, and potential competitive threats. We believe the shorts are wrong. Vistaprint’s unit economics remain solid, and its growth potential is significant. Despite the stock’s recent run, we think potentially quite significant upside remains.  

Business Description / Quality:

• Vistaprint is an internet-based provider of professional quality graphics design and short-run print services for micro and small businesses. Products include business cards, postcards, brochures, signage, holiday cards, and promotional products. In addition to physical print products, the company also sells digital marketing services. These include website and Facebook page builders, and email marketing services.  
• Vistaprint has brought low-cost economics to short-run production jobs for the micro business print market. The company aggregates orders using pre-press software, and prints in facilities in Canada, the Netherlands, and Australia. By aggregating large order volumes, the company produces high quality prints at fraction of the cost of local print stores. 
• Vistaprint is a disruptive business. It enables micro businesses to get great looking design, print, and marketing services at a fraction of the cost of its brick-and-mortar competitors. The company also offers a selection of designs and print sizes that can’t be found at mom-and-pops. 
• Vistaprint has created a sustainable competitive advantage in the core micro business print market:
  • Cumulative investment of over $1bn in software, customization, and capex has positioned Vistaprint as the low-cost, 800 lb gorilla in the market
  • The company is many times larger than its closest peer
  • Potential entrants can’t afford to spend $27 to acquire a customer, and they can’t win on organic search
  • Estimated revenue by product type
    • Business cards: 30%
    • Business related print products: 33%
    • Consumer print products: 30%
    • Digital: 7%
    • Revenue by geography
      • North America: 55%
      • Europe: 40%
      • ROW: 5%

Unit Economics:

• Vistaprint acquires customers for ~$27 via paid search, radio, and broadcast advertising.
• The average transaction size is ~$36, but an acquired customer will typically spend ~$50 in the first year.
• Gross margins are 66%, so new customers make a positive contribution in the first year.
• The consolidated retention rate is ~41%. The company does not provide retention rates by cohort, but retention rates in the 1^st year are probably ~20%, with rates moving closer to ~80% beyond that.
• As last reported, the average lifetime gross profit for a customer is ~$150, demonstrating the inherent profitability of the customer acquisition model. 
• On a trailing 12-month basis, Vistaprint has processed orders from over 15mm unique customers. Of these customers, over 5mm made purchases more than 12 months ago (i.e. repeat customers). These repeat customers each spend ~$98 per year, and represent ~48% of print revenue. This annuity will grow, as new customers are converted into repeat customers next year.
• Customers that stay beyond the second year tend to spend more in the third year than in the second year.

Investment Thesis:

Vistaprint is a disruptive player in the micro business print market. Its highly incentivized management team has used refined customer acquisition techniques, low-cost manufacturing, and existing scale benefits to solidify its position as the 800-pound gorilla in the market.  Recent investments to improve the customer experience leave Vistaprint well positioned to capture share of its large TAM and expand margins. The company’s flexible cost structure provides margin of safety if growth slows, and suggests margins at maturity will be well above current levels.  Despite the optics of reported financials, the underlying business is a cash cow.  In addition to excellent future prospects for the core business, investments in digital marketing solutions and emerging markets add a layer of significant option value to the thesis. 

Key Thesis Points:

• Large TAM & fragmented market:
  • Vistaprint’s core TAM is the micro business with 0-4 employees. Our research suggests that ~50% of micro business printing in the U.S. still occurs at local print stores. In Europe, brick-and-mortar’s share is likely higher. Three primary forces will continue to drive micro business printing online: 1) The value proposition of online printing is superior to that of brick-and-mortar 2) ~5% of the ~9,000 lithographic print establishments in the U.S. close each year 3) Over time, young business owners who are more comfortable with the internet, will represent a larger share of the addressable market.
  • Vistaprint is positioned to capture share from a myriad of smaller online players. Research suggests these players still control ~50-80% of the online market, with most generating minimal or no profit. Some sites have already closed. These players can’t compete with Vistaprint for new customers, and they can’t compete with Vistaprint’s prices.  

• Flexibility in cost structure: Reported operating margins will have compressed ~800bps between FY 2011 and FY 2013E, despite a ~100bps improvement in gross margins. An increase in customer acquisition costs that accompanied a new advertising strategy accounts for ~350bps of the margin erosion. Expenses that seem mostly discretionary account for the remainder. Incremental technology & developed expenses are driving gross margins higher; incremental expenses related to customer service are driving increases in the net promoter score; expenses in emerging markets are positioning Vistaprint to replicate its business model abroad.      

• Highly incentivized management: When management decided to part with consistent 10%+ net income margins, they agreed to forego the majority of their cash bonuses. Instead, they were issued options with a strike price of $50. Robert Keane, the CEO, was also issued options with a strike price of $50. However, he can only exercise the options if the stock reaches $75. In addition to his options, Keane owns ~$90mm of common stock.

• Business run like a private company: To the dismay of legacy investors, Keane is purely focused on creating long-term value. Unlike most public company CEOs, he is willing to sacrifice near-term profitability in order to best position the company for future success. EPS in any given year is mostly engineered by Keane, but he remains committed to delivering $220mm of net income in 2016E.

• Aggressive capital allocation: Management has repurchased over 20% of outstanding shares, for ~$400mm, since entering an investment cycle in 2011. In addition to the shares already purchased, management recently received authorization to repurchase another 6.8mm shares. This represents 20% of shares currently outstanding. In concert with the new authorization, management increased its borrowing capacity. The company currently has ~$240mm of available borrowing capacity.

• Recent investments make long-term financial sense:
  • Increased television advertising: Given average lifetime gross profit of ~$150 per customer, it makes sense to spend more to acquire customers and build a brand.
  • Improved website: Management has completely revamped its website, streamlining the way merchandise is displayed. The new structure may leave customers less likely to splurge on impulse products, but it drives customers towards sticky products they are likely to reorder.
  • Decreased cross-sell and spam: These moves are detrimental to average ticket, but result in a higher net promoter score, which should drive longer term retention.   
  • Improved card-stock: Detrimental to gross margins, which have still improved, but has clear benefits when it comes to retaining customers.  

• Digital opportunity: Digital represents only ~7% of sales. Via the acquisition of Webs, Vistaprint acquired 8mm, mostly under-monetized, active customers. If they are able to improve Webs monetization, or attract legacy print customers to the platform, they may be able to accelerate digital growth. Any incremental digital growth would mostly flow through to EBIT. Given traffic and brand awareness, Vistaprint is well positioned to acquire digital customers at minimal to no cost. This should leave Vistaprint advantaged relative to digital-only players such as Constant Contact.

• Emerging market option value: Management is investing in emerging markets in hopes of replicating its success abroad.

Key Investment Risks:

• Not completely immune from future competition: Vistaprint has created a sizeable moat for all but the most deep-pocketed potential entrants. Industry participants such as Shutterfly could look to enter the market, but they would have to change their go-to-market strategy and invest heavily.

• Fact pattern looks poor: 
  • The business had ~11% operating margins for five consecutive years prior to entering its recent investment phase. Management historically guided investors to expect margins to remain in that range. When the company announced it would enter an investment cycle, investors were caught by surprise. 
  • Organic growth has not accelerated since entering the investment cycle. U.S. growth has remained in the high teens, but European growth rapidly decelerated toward mid-single digits. Bulls believe the rapid deceleration in Europe was likely self-inflicted or macro related, as there have been no significant changes to the competitive environment. Our work suggests that online is less penetrated in Europe than in the U.S., and there should be plenty of run-way for growth.
  • The cost of customer acquisition has inflated with the ramp in television advertising efforts
  • Improving retention was a key goal of management’s investment strategy. The initiatives appeared to be succeeding, with TTM retention improving 200bps from Q4 ‘11 through Q2 ‘13. However, retention slipped in recent quarters. Excluding a negative impact from retail partners, retention would have been flat sequentially.  
  • Management made two optically expensive acquisitions in 2012. They purchased Webs and its 8mm digital customers for $118mm, or13x sales. They also acquired Albumprinter for €60mm, or 10x trailing EBITDA. The Webs acquisition looks defensive, but if management converts a small percentage of users to recurring print customers, they can easily justify the purchase price.          

• Europe has stalled: Management neither provided a sound excuse nor suggested growth will accelerate in the near term. Bears argue that Europe’s local markets are more competitive and scale advantages are less relevant. They argue that differing preferences between geographies makes a one-size-fits-all approach less effective. Bulls counter with: 1) The EMEA market is less penetrated than the U.S. market, 2) The issues have been mostly self-inflicted. The company dramatically reduced the number of emails sent to customers, revamped its website, and reduced cross-sell. They made these changes before refining their new advertising strategy, and 3) Legacy EMEA management has been replaced, and it will take time for changes made by the new management to be reflected in performance

• The consumer business, which represents ~30% of sales, is more competitive than the micro business print market.  

• A “Profit DNA” culture may preclude success in the higher end of market: Larger customers require more design assistance and customer service. These customers can contribute significant gross margin dollars, but would likely flow through at lower gross margins. Management may be unwilling to sacrifice gross margins to attack the market.

• Investors are putting significant faith in the CEO 

Valuation

• A wide range of outcomes are possible, but we believe management has the ability to tweak operating expenses to drive free cash flow growth under any scenario. Our base case assumes management achieves its FY 2016 net income guidance of $220mm. Guidance can be achieved if growth accelerates, or if management pulls back operating expenses. Adding back $30mm for stock based compensation and another $10mm for the delta between D&A and maintenance capex, implies free cash flow of $260mm, or ~$7.50 per share using today’s share count. Applying a conservative 10x multiple to this figure suggests a target price of $75, a 46% premium to the current stock price.
• A number of bull cases exist that could result in Vistaprint generating closer to $10 of free cash flow per share in FY 2016E. Variables that could contribute to such a scenario include: 1) Significant repurchases under the current authorization 2) Success with the digital initiatives 3) Success in emerging markets, or 4) a significant pull-back in technology spend and reduction in capex.       
• If the bears a partially correct, and growth slows, management will flex expenses and manage a mature business. In this scenario, we believe the company can still generate ~$4.00 of free cash flow per share. Applying a modest 9x multiple, implies a share price of $36, a (30)% discount to current levels.

Disclaimer: We and our affiliates are long VPRT. We may buy or sell shares without notification. This is not a recommendation to buy or sell shares.