Description

VALASSIS COMMUNICATIONS (VCI-$28)

It is a leading printer and publisher of cents-off coupons and other customer purchase incentives primarily for package goods manufactures. They are mainly distributed as Free-standing inserts (FSI’s) which are booklets containing coupons inserted into Sunday newspapers.

Positives

1. Very strong market position: VCI controls 50 % of the FSI market (75% of revenue), it shares the market with a division of News Corp. You need strong relationships with both the newspapers and consumer companies, to be successful in the market. Companies have tried to enter the market in the past and failed. News Corp. is a tough competitor, which means pricing is not out of line with alternative advertising mediums, an investment positive.

2. Outstanding returns: Return on total assets is in excess of 60%, operating margins are 28.5%, and free cash flow generation is 15% of sales. I believe this validates the quality of the business. In addition ad space is sold in advance of publication, which means this business can operate and grow with negative working capital.

3. Stock Buy-Back: Management has stated that they will use the free cash flow to pay down debt and buy-back stock in equal amounts. They spent $80m in share repurchases last year and have already spent $80m this year. They have retired 17% of the stock in the last 5 years in addition to reducing Long-term debt over the same period by $125m. By all accounts management has become more aggressive on their stock buyback program in the last couple of months.

4. Growth: The company believes the FSI business will grow 4-6%, while this does not seem impressive there is a great deal of operational leverage in the structure, which with flat costs would lead to 20% operating profit growth. (Management in the annual report outlines the efficiencies they believe they will be able to take advantage of). The other 25% of the business consists of more company specific promotional materials that are expected to grow 15% by revenue with substantial margin opportunities. Long-term EPS growth (given stock buybacks and debt reduction) seem likely to be in the 12% to 15% range.

Negatives

1. Newsprint prices: This accounts for 44% of the cost base, long-term hedging and collar programs have reduced the short-term risks to manageable levels. But this is a very important input for the company and should be watched.

2. Advertising volumes: Advertising volumes are cyclical, however promotional (i.e. Coupons) spending normally increases in a tough advertising environment.

3. Internet: Unless the pie increases any new advertising medium is likely to impact advertising spending in traditional categories. Management has been quite aggressive in online ventures. They started Save.com (downloading of coupons), they own 10% of Coupons.com in addition to other investments. Losses should be less than $5m for these initiatives in 2000.

4. Contract negotiations: There is some short-term concern over contract negotiations and what is called remnent pricing (the left over space in a FSI booklet). This is likely to be short term in nature.

Valuation

The company sells for 11.8x this years EPS, and 10x reduced estimates for next year. I believe this is a unique company with a true franchise value. The earnings are all free cash given that management expects $15m in cap ex. for the next few years. This is the lowest multiple of TTM and forward earnings that VCI has traded on in the last 5 years. This is a company that has consistently traded in excess of 20x earnings, and given the margins and defendable market position should do so again in the future. Which gives me a target price of $56 per share.

Catalyst