VPRT Writeup

Vistaprint is a printing company that caters to ultra-small businesses. We would characterize the company’s primary segments as follows:

• Print-based marketing services - Essentially, Vistaprint prints marketing materials for its customers in the form of business cards, brochures, posters, letterhead, etc. This is the company’s most well-known business and the one that currently generates the vast majority of its revenues.
• Print-based home and family products such as photo albums, calendars, invitations, bumper stickers, thank-you cards, etc.
• Non-print-based marketing services - this includes stuff like logo design, embroidered apparel, and most importantly, internet marketing, all catering specifically to very small businesses. The internet marketing business itself includes website design tools through the recently acquired Webs platform, as well as a small time email marketing operation, local search profile help, etc. Currently, this segment produces negligible revenue and even more negligible profits. In our analysis of the entire company, we basically omit this segment as it’s impossible to value - if successful, it could be a very significant driver of long term revenue and earnings growth. If unsuccessful, well, you’re really not paying for it so it doesn’t matter.

We believe that the market fundamentally misunderstands Vistaprint’s growth-oriented but extremely flexible business model and expense structure. Growth-oriented investors see a company that is growing revenue and earnings in excess of 20% annually and happily buy the stock (irrespective of valuation) when things are going well, while punishing the stock when results disappoint and seem to imply a slowing growth rate. Value investors, on the other hand, would almost never touch a company with a >20x multiple of earnings and a >15x multiple of free cash flow.

The VPRT Business Model

We’ve laid out selected historical financial data from Vistaprint’s income and cashflow statements below. You can see that Vistaprint has grown extremely rapidly over the past few years with EBIT margins consistently in the 10-12% range and EBITDA margins in the 20% range (we exclude both D&A AND share-based comp in our EBITDA calculation; as usual, we account for  share based comp by fully diluting the share count by all in-the-money-options currently outstanding as well as estimating the annual percentage share dilution going forward and penalizing our growth rate numbers by that amount).



The few lines at the bottom of the table highlight the key factors that Vistaprint breaks out in order to understand what drives the company’s growth:

• New customers acquired - this is the lifeblood of revenue growth. The more new customers are acquired, the more new customer revenue is generated, and the more customers are retained. Customers are acquired via advertising, both through internet as well as “old media” channels. New customers acquisition is of course inextricably linked to the last line in the table - cost of customer acquisition (COCA). You can see that the COCA has steadily increased since 2007, but not at an alarming pace - total advertising expense has increased close to 300% in that time while the average cost of customer acquisition has only increased by about 50%.
• Retained customers - the more customers VPRT is able to retain, the better, for two reasons: 1) you only need to acquire a customer once, meaning that the incremental margin on retained customer revenue is enormous and 2) as you can see in those bottom few lines, the average spend per retained customer is close to double the average spend of a new customer.
• Spend/customer - this is pretty obvious - as the average customer spend increases, revenue increases even without a commensurate increase in unique customers. Vistaprint has actually been fairly successful increasing the average spend/customer over its history.

You quickly realize, though, that what really drives Vistaprint’s cash flows is its customer retention rate - how many year-1 customers continue to buy in year 2? How many year-2 customers stay to buy in year 3? For Vistaprint, a new customer results in a slight loss in year 1 once you account for the cost of acquisition. But beyond that, incremental sales carry high incremental margins (>35%).

Vistaprint is understandably vague about its customer retention rates, but management has explained that there is (obviously) a steep falloff in the number of customers retained from year 1 to year 2, but that the percentage falloff each year beyond year 2 is fairly steady and low. Through a bit of trial and error (and some simple linear algebra), we’ve approximated the retention rate to be ~20% from year 1 to year 2, and 90% beyond that. In other words, only one fifth of new customers stay with Vistaprint, but once they’ve stayed, they stick around for a long time - Vistaprint only loses ~10% of its retained customer base from one year to the next.

To summarize: advertising leads to new customers, leads to retained customers, leads to profits. And retained customers are a function of the retention rate.

A Hypothetically Mature VPRT

Given the above business model, the factor that Vistaprint can control most directly is the amount of money it spends on advertising. Assuming a COCA that continues to rise at a slower pace than overall advertising spend, the more advertising Vistaprint does, the more new customers it will acquire in a particular period (there are of course limits on the level of COCA that will result in a positive NPV, but Vistaprint has not come close to that point).

One way to look at Vistaprint’s value is to try and figure out what its steady-state cashflow would be if the company only spent enough on advertising to maintain its base of retained customers. Using the 2011 numbers as a blueprint, we would assume:

• A $24 COCA, which is likely significantly overstated given that at a reduced level of advertising spend, COCA would most probably be lower.
• A constant retention rate, which is also conservative given that this has risen over the years (as per management) and Vistaprint is actually working hard on getting the number even higher.
• A constant margin structure - if Vistaprint actually went into mature-company mode, we’d bet they could juice their margins by even more than just a lower advertising expense, but for now, we could assume margins remain somewhat constant. This means a 65% gross margin, 11.5% technology & development expense rate, 12% marketing & selling expense rate, and a 9% G&A rate.
• A goal of maintaining an approximate 5M retained-customer base (which is about what the retained base will be by the end of FY12 based on the FY11 new customers acquired and the historical retention rate).
• No growth in spend/customer - this is also likely a conservative assumption given Vistaprint’s historical success in raising this number.

• Massively increase advertising spend as a percentage of revenues in the near term. Vistaprint is going from Advertising at 21.5% of revenues in FY11 to over 25% of revenues in FY12.
• Put in place multiple efforts to increase customer loyalty so as to increase the retention rate as well as the spend-per-retained-customer. These efforts include fewer annoying cross-selling offers, higher quality of product, better customer service, increased quality of marketing emails commensurate with decreased quantity, etc.
• Significantly increase manufacturing efficiencies in the printing process in order to raise gross margins over time and truly take advantage of their relatively large (for a printer) revenue base.
• Slowly expanding the company’s product line and customer base from its core ultra-small-business customer to more home & family business and more bigger-small-business revenue.

So Vistaprint is attempting accelerate the growth of its new customer base and the resulting retained customer base. At the same time, the company is putting in place initiatives that are meant to increase retention rates and spend-per-customer, increasing the overall return on investment from the acquisition of a new customer. Will this work? It really depends on how much Vistaprint is spending to acquire a customer. At current rates (in 2011, the company spent $24 per new customer acquired), Vistaprint is getting a very high rate of return and has plenty of room to raise the COCA, even without any improvement in customer retention or in spend-per-customer. Thus far for FY12, the COCA has been in the $26-27 range, a 10% increase from 2011, but on an advertising budget increase of >40%.

If Vistaprint can consistently keep the growth in its COCA at a fraction of its overall advertising spend growth, then their runway to grow double digits is at least several years long. The great thing about Vistaprint, though, is that once it’s clear that they’ve hit the wall with regard to the marginal returns on advertising spending, they can cut back on that spending quickly, increasing their free cash flow in the process. The advertising budget is not like a factory with a sunk cost that they need to keep running just to stay cash flow positive. That’s why we think it makes sense to view Vistaprint from the hypothetical perspective we outlined in the previous section - because the advertising spend is extremely flexible and can be adjusted based on its expected return.

In order to arrive at a number useful for valuation purposes, we ran the same hypothetical simulation as above, but accounted for the large increase in advertising and new customers during the current fiscal year. Based on Vistaprint’s current plan for FY12 advertising spending, and using the historical retention rates and FY11 spend/customer numbers, we expect that by the end of the current in fiscal year (in July), Vistaprint’s mature-company EBITDA and FCF potential will be in the range of $250M and $180M, respectively, a 25% increase from FY11. Of course, they will not actually generate that because they’ll continue growing their advertising budget given the still-solid ROI that it is generating. At the current stock price, we believe that an investor is receiving a slow-growing 11-12% FCF yield at worst, and a rapidly-growing for-a-long-time-to-come 6% FCF yield at best. Furthermore, as long as Vistaprint is growing and getting a good return on its advertising spend, it is also increasing its FCF-generating capability at maturity. Thus, we expect the mature-state $250M in EBITDA and $180M in FCF to continue to grow over time.

Quality of the Business

Over the past five years, Vistaprint has generated pre-tax returns on invested capital in the 30-50% range consistently. Still, when we’ve discussed Vistaprint with other investors, the number one retort has been - “why can’t anyone with enough capital just open up a printer company to compete with Vistaprint?”

Our answer is that just to replicate what Vistaprint has done up until now - on paper - would require ~$1.25B in spend. Here’s how we figure: At year-end FY12, we expect a retained customer base of ~5M and new customer base of ~9.5M. Assuming that this new entrant could match Vistaprint’s COCA, retention rates, and spend/customer, it would cost about $950M. Of course, it’s would be tough to match Vistaprint’s COCA number given Vistaprint’s decade of experience tinkering with maximizing the ROI on its advertising spend, plus the fact that the new competitor would have to compete with Vistaprint for every new customer, which Vistaprint does not currently have to do given no competitors that come close to its size. Similarly, Vistaprint’s retention rates and spend/customer are the product of years of improving on those numbers through trial and error. It would be close to impossible for a new entrant to get to that level of efficiency from the get-go.

On top of the $950M in advertising expense, the new entrant would have to spend about $300M on PP&E and software, and that’s the depreciated number. The from-scratch number is likely higher. So we’re at $1.25B, and we haven’t accounted for the intangibles - management’s experience running the business, the Vistaprint brand, the significant strides that Vistaprint has made in improving its back-end manufacturing and shipping operations, the acquisitions Vistaprint has made recently, the marketing intelligence acquired over the years, etc. Suffice it to say, that it would probably be safer for this new entrant to buy Vistaprint at its current valuation - $1.59B, allowing for all option dilution - than try to reinvent the wheel.

As for the current competition, it’s hard to compete with Vistaprint given its scale. Vistaprint’s current revenues are about five times the size of its nearest public competitor - the printing business of Deluxe Corporation. That operation - PS Printing - has about $200M in sales and at that level cannot come close to matching the economies of scale that Vistaprint possesses in advertising, shipping costs, manufacturing scale, breadth of product, and quality of design. Design in particular gets less attention than it should from investors - feel free to check out PS Printing’s website and ask yourself if you’d allow a company with a website like that to print your business cards and letterhead just to save, literally, two or three dollars.

Beyond other online printers, Vistaprint’s primary competition is the average mom-and-pop printer, and the cost advantages that Vistaprint has relative to the mom-and-pops is probably insurmountable in the long run. There’s plenty of room for Vistaprint to gain share in this deeply fragmented industry where almost no one can compete with Vistaprint on price due to scale.

In sum, we are arguing that Vistaprint is a company that is very hard to replicate, extremely tough to compete with, operating in a super-fragmented business and thus with significant room to run in gaining share on structurally disadvantaged competitors.

Other Points to Ponder

There are a few other things to keep in mind as you consider Vistaprint:

• Everything discussed up until now relates to Vistaprint’s core printing business. In recent years, Vistaprint has started an internet marketing operation catering to small business. As Vistaprint struggled to gain a foothold in the business, it agreed last quarter to buys Webs - which is regarded as the premier service provider to ultra-small-businesses in the field of website design and marketing. Realistically, Vistaprint paid a steep price for Webs - $100M. We honestly have no clue how successful Vistaprint will be with the website business, but a few things do bode well:
• Webs itself is a truly phenomenal platform. We’ve used it ourselves and have spoken to many other who have also used it. It’s free, which is obviously nice from a user standpoint, and doesn’t cost Vistaprint much to run because Vistaprint is not actually doing the server hosting. For small companies that get more serious about having a more professional online presence, there’s a subscription stream in here that could be significant as the company grows rapidly.
• The Webs platform will benefit from Vistaprint’s years of marketing experience and Vistaprint’s vast database of email addresses and customer information of ultra-small businesses, which are exactly the target market for Webs.
• The above marketing benefit also works in reverse - Webs currently has a huge roster of users that Vistaprint does not currently sell its products to. Even if Vistaprint is just able to hit up the free users on the Webs platform and get some of them to buy printed products for Vistaprint, it will get some sort of return from its investment.
• Most importantly, because it’s early days, we have no way to ascribe any value to this business, so we consider it totally free upside at the current price.

• We have a lot of respect for the management here. While these guys are a bit promotional, there are a few management characteristics we really like:
• The disclosure is phenomenal and management does not try to hide anything. In fact, the company has been great in increasing the amount of disclosed information and statistics without obscuring when something doesn’t go their way.
• Management does not really care what Wall Street thinks of its investment plans. While this cuts both ways, we are actually impressed with the logic behind the company’s growth plans even in the face of Wall Street punishment (see the stock price reaction last July when the new advertising strategy, i.e. increased spend, was announced.
• Robert Keane owns 8% of the shares outstanding. It’s not every day you have a billion dollar company with significant insider ownership, which assures you that at least he cares. It’s also not dual class ownership where Keane gets to vote, and everyone else can go fly a kite.
• Vistaprint actually buys back shares opportunistically, not only for BS reasons like offsetting options issuance. The best example of this is that in the two months after the stock got hammered in the summer for the new strategic initiative which would hit earnings in the ensuing year, the company bought back about 15% of the shares outstanding. In other words, the company actually cares to buy when its stock is cheap.
• The above points regarding management also give us confidence that they will not over-extend their advertising expenses just to show revenue growth. Management seems to be ROI-driven. Of course, anything could happen and the lure of “growth” and Wall Street cheerleading are hard to resist. Still, if there’s a management team that could do it, it’s Keane’s.

• Finally, just for your information, Vistaprint dilutes anywhere from 0.5-1.5% of its shareholder base annually through the issuance of stock options and restricted stock units. In the numbers we used above, we fully diluted all options that are currently outstanding. Regarding options that are issued on an annual basis, we don’t really consider that full dilution because frankly, the exercisers will have to pay in the strike price at issuance. RSUs are a bit different and we consider them to be full dilution. Vistaprint has been adamant that it is moving off of the share-based comp approach to management compensation and more towards cash. We’ll believe it when we see it. For now, we’d consider it realistic to somewhat conservative to penalize the FCF yield numbers or the growth numbers by a full percentage point. Either way, it does not do much to our valuation and the attractiveness of the shares.

Risks

There are always risks. The key risks to the Vistaprint investment thesis are:

• Dumb acquisitions - so far, we’re giving Keane & company the benefit of the doubt regarding the $100M Webs acquisition. If there are any other big ones, we’ll start questioning ourselves.
• Overpaying for growth - as we mentioned a few paragraphs ago - it’s possible that management will advertise more aggressively than warranted in order to grow the customer base. We’re watching the COCA carefully, in addition to average spend/customer and average retention rates.
• This market is really nuts. At least Vistaprint is not operating at peak profit margins and trading at 15x FCF when its long term sustainable growth rate is only 5% (or less). If this market takes a dive, well, you can always hedge with SPX puts (as we do).

Re-accelerated growth due to increase in advertising