Description
X-Rite is a company that produces color management equipment and software for a variety of end markets.
This summer X-Rite, which was the largest company in the color management space, merged with Amazys which was the second largest company. Amazys is located in Switzerland and shareholders received three quarters of their compensation in cash and one quarter in stock, which meant there were about 7 million shares of stock added to the float held by people who were mostly cashed out and living on another continent.
To make matters worse, customers have delayed purchases from both Amazys and X-Rite as they waited for the merger to close. As a result both companies experienced flattish sales in the first half of the year, which was well below expectations. The next twelve months are unlikely to be all that much prettier from a top-line perspective as the companies consolidate and salespeople are let go. The company has guided to first half 2007 sales that will be flat with first half of 2005.
Against this backdrop, the company’s stock sank from 13 to about 8 and has since recovered to about $10.30. The company today has about 28 million shares outstanding and about $190 million in net debt (not including founder’s life insurance which I will discuss later)
Lost in the short-term financial and technical noise is the soundness of the merger. Although the merger documents and the company’s presentation estimates that X-Rite and Amazys together are about a quarter of the overall billion dollar color market. The next largest competitor, Datacolor, is 6.4%. My suspicion is that the new X-Rite’s market share is well in excess of 25% in those color management markets that it competes in. After the merger, X-Rite will have an R&D budget multiple times larger than its nearest competitor, which should allow it to bring better products to market and potentially widen its moat. (I would encourage anyone interested to run some searches of X-Rite product on the web and see if any competitors are mentioned besides Gretag-Macbeth – which is Amazys’s product line – and Datacolor)
In addition, there are major cost synergies that will come from combining the two companies. Management estimates that it will be able to reduce headcount by approximately 20 percent and that it will be able to produce most of the Amazys product in X-Rite facilities. All in, management expects run-rate cost saves of about $25 million dollars by the middle of 2009, which is less than 10 percent of cost of goods sold plus less than 15 percent of other operating costs. In addition, as a result of the merger, X-Rite will be amortizing about $10 million a year of intangibles, which will depress stated earnings but will result in significant tax savings.
Modeling X-Rite requires making a variety of assumptions. Below are my estimates through 2010. Essentially what is incorporated is the following.
- Excluding charges, 2006 will be flat to pro-forma 2005. The only exceptions are that there will be no gain from sale of founder life insurance policies and that the $3.8 million dollar earn out at Amazys last year will not recur.
- Growth will be 4% in 2007 and 6% thereafter. This amount is less than the approximately 9 percent growth that the combined X-Rite would have experience from 2001 until the end of this year, assuming that this year is flat.
- Merger synergies take a little bit longer than the company projects.
- Operating income contribution margins work out to be about 22% more or less on incremental sales on top of merger savings. (I actually modeled each line out separately and so there is variance from this in any given year but the result across the entire period is close to this number). Between 2001 and 2006, contribution margins at X-Rite appear to me to have been a little in excess of 30 percent. That number is very erratic from year to year, which makes a contribution margin assumption nothing more than a best guess but with a gross margin in excess of 60 percent, a low 20s contribution margin does not seem unreasonable to me.
- The tax shield from amortization is about $10 million a year. This shield reduced GAAP income by about $7 million a year.
- The company uses its excess cash flow to pay down debt.
- The gains from recent sale of headquarters more or less offsets the 20 million dollar restructuring charge that is coming this quarter.
|
|
2005 Pro Forma |
2006 |
2007 |
2008 |
2009 |
2010 |
|
Net sales |
245,927 |
245,927 |
255,764 |
271,110 |
287,377 |
304,619 |
|
Cost of sales |
100,818 |
100,818 |
99,306 |
103,733 |
107,203 |
113,755 |
|
Growth |
|
|
4% |
6% |
6% |
6% |
|
Gross profit |
145,109 |
145,109 |
156,458 |
167,377 |
180,173 |
190,864 |
|
Gross margin |
59% |
59% |
61% |
62% |
63% |
63% |
|
Operating expenses: |
|
|
|
|
|
|
|
Selling and marketing |
65,885 |
62,085 |
60,462 |
61,111 |
62,888 |
64,802 |
|
Percent of revs |
27% |
25% |
24% |
23% |
22% |
21% |
|
Research, development and engineering |
28,569 |
28,569 |
27,220 |
29,461 |
31,744 |
33,069 |
|
Percent of revs |
12% |
12% |
11% |
11% |
11% |
11% |
|
General and administrative |
39,146 |
39,146 |
37,130 |
37,664 |
38,291 |
39,515 |
|
Percent of revs |
16% |
16% |
15% |
14% |
13% |
13% |
|
Insurance policy gain |
(1,154) |
0 |
0 |
0 |
0 |
0 |
|
Total |
132,446 |
132,446 |
124,812 |
128,236 |
132,923 |
137,386 |
|
|
|
|
|
|
|
|
|
Operating income |
12,663 |
15,309 |
31,647 |
39,141 |
47,251 |
53,478 |
|
EBIT Margin |
5% |
6% |
12% |
14% |
16% |
18% |
|
Interest and other income (expense) |
(16,486) |
(16,486) |
(16,486) |
(13,551) |
(11,318) |
(8,506) |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Income (loss) before income taxes |
(3,823) |
(1,177) |
15,161 |
25,590 |
35,933 |
44,972 |
|
|
|
|
|
|
|
|
|
Income taxes (benefit) |
(2,879) |
(353) |
4,548 |
7,677 |
10,780 |
13,492 |
|
Tax Rate |
|
30% |
30% |
30% |
30% |
30% |
|
Net income (loss) |
(944) |
(824) |
10,613 |
17,913 |
25,153 |
31,480 |
|
|
|
|
|
|
|
|
|
Earnings (loss) per share: |
|
|
|
|
|
|
|
GAAP EPS |
(0.03) |
(0.03) |
0.37 |
0.63 |
0.89 |
1.11 |
|
Cash EPS |
|
|
0.73 |
0.98 |
1.24 |
1.46 |
|
Intangibles Amortization |
|
|
10000 |
10000 |
10000 |
10000 |
|
Debt Beginning |
|
190,000 |
190,000 |
169,387 |
141,474 |
106,321 |
|
Debt End |
|
190,000 |
169,387 |
141,474 |
106,321 |
64,841 |
|
Interest Rate |
|
|
8% |
8% |
8% |
8% |
|
|
|
|
|
|
|
|
|
Merger Savings |
|
|
11,500 |
17,500 |
21,500 |
25000 |
On these assumptions (that the overall company grows less than it did historically and that the merger synergies take longer to happen than management is guiding), the company will do about $1.40 - $1.50 in cash EPS in 2010. Conservatively, I think the market would put at least a 16-18 multiple on those earnings by the beginning of 2010, which means that from here XRIT should be better than a double across that time frame. Historically, X-Rite has traded in excess of that multiple and 16-18 times is not unreasonable for a company with good prospects growing mid to high single digits.
The largest risk to the position working is a failure to realize the anticipated synergies in the merger. X-Rite is not a large company and the task in front of them is not simple. According to management, they are on track and the recent naming of the former CEO of Amazys as head of X-Rite (which was supposed to happen within 18 months of completion of the merger) is evidence that they are feeling comfortable with their progress and have their ducks in a row.
Also, in the near term, I would expect a very messy quarter. The company is not closely followed and some analysts have yet to adjust their back half numbers for the merger, which could provide some noise (and perhaps an interesting entry point).
Finally, it is possible that their customers will try to beat X-Rite down on price and that less of the merger synergies will flow through than I am modeling. I think it is equivalently likely that because of the new X-Rite’s market position that they will gain some additional power over price.
On a ghoulish note, one source of upside to my valuation is a hidden asset on X-Rite’s balance sheet. The company lists the cash surrender value of its founder life insurance policies as $20 million. According to the company, the face value of these policies is around $130 million (a little under $5 a share) and all of the founders are at least in their 70s. My understanding is that the cash would come in tax free.
Catalyst
lifting of stock overhang post-merger and realization of merger synergies