Description

Zebra Technologies is specialty printer manufacturer for printing of barcodes, ID cards and photos. ZBRA is down about 50% from its high of around $60 set in the late ’04 and today its stock represents a very good opportunity to buy a great company at a really good price. At $33, I think buyers could make between 30% and 50% from here in the coming 24 months.

Obviously, it is just as easy to read the company description via their website and 10-K, but basically ZBRA makes printers used by various industries – from retailers, government agencies, health care, manufacturers, etc. They have about 30 different printer models that make barcode labels, 10 models that make ID cards and a couple of photo printers sold via their relationship with Kodak into professional photo market. They sell their printers (80% of sales), supplies (18% of sales) and services (4% of sales) almost exclusively through indirect channels of distributors, value-added resellers and OEMs. Geographically, international sales (and this matters below to explain some of the reasons they’ve disappointed recently) have just exceeded 50% of their overall revenue. However, it is still true that sales are still dominated by their slower markets such as the US and Europe. The 25%+ growth in sales into their emerging markets of Latin America, Eastern Europe and Asia-Pacific that represent about 20% of their revenues isn’t yet big enough to offset the slower growth in their major developed markets elsewhere.

Here are some of the numbers behind ZBRA. They have been a darling in the past by growing at rapid rates and by picking up market share as well. Besides the obvious issues felt by all in 2001 and 2002, they recorded high teens revenue growth in the late 90’s and as recent as 2003 and 2004. In 2005, they only were able to grow sales at about 6%. Their first quarter of 2006 - excluding the negative currency comparison – also produced about 6% sales growth. That certainly explains the huge drop in the stock. The sales growth declines are a factor of a couple of primary things; slowing growth in their large US/European retail segment and price competition abroad. ZBRA’s gross margins have historically been around 51% and this past quarter they dropped to 47%. Aside from revenue growth, it is THE major focus of investors going forward, in my opinion. You get the sense that management would be happy to get it back to above 50% but it is possible they would be content with getting to 49%-50%. As a result, their EPS growth between 2004 and the current estimates for 2006 is about flat. The company has basically blamed these results on a changing product mix to lower cost printers and general price competition in their emerging markets.

ZBRA does produce a very healthy profit on its revenue. They currently have operating margins of about 21% to 22% but have historically been able to achieve operating margins in the 25% range. That is still their stated goal and any movement in that direction will be seen as a very bullish sign. Clearly getting there is only possible through better expense management, manufacturing efficiencies, help on the currency front and an easing of pricing pressures. Can it be done? I would only be guessing, but at this point, what I care most about is a stabilization of gross margin compression and good management moves to get to a slightly improving operating margin in total. What can’t be argued is that getting to keep about 22 cents of every dollar of sales is the mark of an extremely good business.

ZBRA has an extremely solid balance sheet that should protect the stock from here. By the end of 2006, they should be sitting on about $650m in cash or about $9 per share with no debt. This represents about 30% of its stock price today. They don’t pay a dividend but have bought back shares. What they plan to do with this cash is not known but it is a good thing to have options. Management has always articulated its desire to acquire other complimentary businesses. This is a stock that has attracted growth investors. Today, with a cash horde that is growing and solid profitability (albeit slowing growth) it is definitely now entering into value manager territory. This is a transition that is not without risk. With time, the growth guys will either re-love the stock or eventually hand it all over the value guys that aren’t looking for much other than moderate improvements to get thing heading north. Buying the stock now probably means you are betting on the growth guys getting pleased by ZBRA’s fundamental improvements – with the deeper value guys never getting the change to enter the stock because it isn’t cheap enough for them

Going forward, ZBRA’s management has stated that the overall industry growth of 10-12% can be juiced by some market share gains by ZBRA. This may be about 2% growth from share gains. Acquisitions are always in their sights and that could increase sales by another 5% or so annually over time. This is what the market has come to expect – perhaps as high as 15% to 20% in overall sales growth. With price competition heating up and its major markets slowing, along with currency fluctuations that always wil occur, it will likely drop their long range growth estimates down to a more reasonable 10% to 15%. Today, you are seeing estimates in the 6%-7% range for 2006 and 2007. Again, this explains its recent stock performance but the bar has been set pretty low here.

So, here is list of the bad stuff that is happening:

- Gross margins compressing by about 4% this past quarter and likely to settle in to about a 2% drop from historical norms.
- Its major markets of North America and Europe grew 3% in the first quarter vs. last year.
- New products introductions have and will continue to pressure gross margins – but this is really a good thing over the longer term. In the past about 20% of their sales came from new products. That figure now stands at closer to 10% of sales. All investors want innovation to happen and accelerating new product introduction typically hurts profitability in the shorter-term.
- Their days-sales-outstanding number looked weaker in the first quarter – blamed it on big orders near the end of the quarter – I am not too worried about this.
- They lowered earnings guidance for the upcoming quarter – again due to margins falling. This is the focus. Sales guidance was actually not much different from estimates at the time.
- The commented on price sensitive customers especially in fast growing emerging markets.
- Current patent litigation with Paxar – I can’t comment on this intelligently – read the 10-K to get a brief feel on how bad this could be. Management has estimated a top end estimate of about $50 million or less than $1 per share. Ongoing expense could be royalty payments, I guess – but that is all that is, a guess.

On the flip-side, here are the good things:

- Asia-Pacific and Latin American sales were up 22% and 28% respectively
- With a stable currency in the 1st quarter, they would have gotten 6% revenue growth. Not great, but it is certainly better than 3% as reported. This 2nd quarter currency effect will be about neutral as it stands today. There was hefty drop in the dollar in the 2nd quarter 2005 as there has been during this quarter. Overall, the dollar falling and the company not hedging too aggressively will work in ZBRA’s favor.
- Unit growth in printers for ZBRA was up 10-12% but overall pricing largely negating the affects. While obviously not knowing for sure, I would suspect that pricing will stabilize at some point and allow the good unit growth to flow through to the revenue line.
- They secured a distribution deal with Magnet to accelerate its entry into the health care market – a positive sign of new market penetration and expanded use of their technologies.

Since the stock has fallen about 50% off its high, at around $33 with $9 in net cash by the end of the year, ZBRA is cheap, in my opinion – that is, if it can show any strength on the revenue and margin side. I clearly think it can. This belief is based on its dominant position a generally growing industry, its history of being able to grow, its future boost to growth via the much talked about RFID market (not worth mentioning yet because it is so new and is currently immaterial to their results) and its very strong balance sheet that give them numerous options to increase shareholder value.

At $24 net of its cash, ZBRA sells for about 15x its $1.65 EPS ex-cash interest. In my opinion, if anything bearish can be said about this valuation, it is that it is “fair” considering their slowing growth and margin issues. It may very well turn out that way. But, on the other hand, my bet is that with a return to 10% sales growth in any of the upcoming quarters – maybe well in to 2007 – along with an improvement in gross margins, will allow this stock to trade with at least a 20x multiple again. If by mid-2007 that transpires, a 20x multiple on 1.80 EPS ex cash interest estimate for the then coming ’08 fiscal year plus the accumulated cash could result in a stock in the $45 to $50 range. At $33 today, ZBRA represents a 30% to 50% return opportunity within the next couple of years. If, on the other hand, nothing moderately good transpires and the negatives become the new norm, then I truly don’t see the stock falling much below $30. ZBRA represents a risk/reward tradeoff that is worth taking.

Catalyst

- improved gross margins
- improved sales growth
- balance sheet strength