By Daniel Kaskawits, CFA ()
Investment Thesis – Bowne’s stock has been beaten down because of the cloudiness around earnings related to recent acquisitions and exacerbated by the slump in capital markets transactions. However, Bowne will benefit from three factors coming out of the economic downturn: 1) a modest and gradual rebound to a normalized environment in capital markets activity (IPO’s and M&A), which is Bowne’s most profitable business; 2) an increase in regulatory disclosure requirements, including the roll-out of XBRL (electronic tagging of financial statements); and 3), inherent operating leverage that will result from Bowne’s substantive cost cutting measures over the past two years, totaling about $100 million annualized.
Founded in 1775, Bowne is the market leading shareholder services firm providing printing, communication and other document services for the transactional, compliance, and corporate and mutual fund reporting requirements of its mostly financial services industry customers. Bowne is generally thought of as a printer, but this is a misunderstanding. Bowne’s sustainable competitive advantage leverages its access to customers and proprietary technologies, via its document creation expertise and end-to-end shareholder services. This will allow the company to evolve with the transition towards electronic distribution and digital content. In fact, Bowne now derives 70% of overall revenue from technology related document management services and just 30% from print.
Bowne’s shareholder services segment has a very sticky customer base and a significant recurring revenue stream. The business can be thought of in two parts: capital markets transactions, which are highly profitable (but cyclical) and consistent and predictable compliance and investment management products, which are less profitable (GM likely ~25%, though management does not break out). On the transactional side, Bowne maintains its competitive advantage through strong relationships, including law firms and investment banks, which are generally price-inelastic given the time-sensitivity of the work. Indeed, Bowne typically captures about 30-40% of IPO and M&A activity, with the remainder falling to RR Donnelly (RRD), Merrill (private), and other smaller players. Meanwhile, compliance and investment management revenue is steadier, consisting of mostly 10K/Q’s, proxies, and prospectuses. Given the likelihood of increased and more complex disclosure mandates (XBRL, MM Funds required to register with SEC in 2010, potential hedge fund regulation), this segment should grow in the mid-to-high single digits for the foreseeable future.
While an upturn in capital markets activity is important for Bowne, my thesis does not rest solely on this outcome. According to my down-case estimates, Bowne would be able to fill a possible capital markets sink-hole by 2011 with compliance/investment management fees. Attaching a below average EBITDA multiple to this pessimistic scenario would still give the stock near 10% upside by 2011.
Valuation and Free Cash Flow – Bowne is trading at 4.7x my 2010 EBITDA estimate (or just about 6.6x EBITDA-MCX). Over the past 15 years, the stock has traded at a normalized mid-cycle 6.25x multiple. Accordingly, I believe the stock is worth $9.70 and could double over the next 2-3 years. Additionally, my estimate carries a free cash flow yield of nearly 10% on 2010 figures and 13% on 2011 forecast. In my down-case scenario, capital markets revenue would languish over the next two years, with margins staying compressed. This would cause the timing of the story to lengthen as higher compliance fees kick in around 2011/2012. Still, based on a 5x multiple and 2011 pessimistic EBITDA, the stock is worth $7.70 (nearly 10% upside). Plus, capex requirements are minor going forward, given the push towards a digital landscape, which should help keep free cash flow healthy – a meaningful change from Bowne’s operations in the past.
Capital Markets Rebound – For Bowne, there is a range of deals from small boilerplate transactions to large, intricate, and hostile takeovers. The latter are the most lucrative as they often require last minute edits by clients who are insensitive to price, as filing fees represent a tiny fraction of the deal bill. Bowne’s capital markets revenue tracks closely to overall trends in M&A activity and IPO Issuance. While it is difficult to project exactly what the trajectory will be coming out of this financial crisis, it seems safe to say that 2009 should represent the trough. A few factors should benefit the near-term recovery, including ample liquidity fueled by Fed-driven restrained interest rates, a pick-up in IPO issuance as part of the overall deleveraging process and exits from the abundance of private equity deals that occurred in 2006/2007, and a corporate appetite for accretive acquisitions as exploitations from cost-cutting measures become more difficult. In my base-case, I assume that Bowne can book capital markets revenue of $150, $170, and $190 million in 2009-2011, while the down-case accords just $160 and $170 million in 2010 and 2011, respectively. This seems reasonable given a typical mid-cycle run-rate of about $250 million. In addition, near-term estimates may be conservative as IPO issuance has accelerated with 33 deals in 4Q.
XBRL – By 2011, it will be an SEC mandate that all companies electronically tag their filings (via XBRL) – in part, so that investors can export data to excel or click on an item for its definition (similar to Cap IQ or FactSet, albeit with less detail), http://www.sec.gov/spotlight/xbrl.shtml. During the 2Q09 filing period, Bowne completed 126 XBRL filings at a 29% market share, which was ahead of their 25% target. Additionally, XBRL Cloud, an independent organization that runs technical audits of XBRL documents, recognized that Bowne completed the highest number of error-free filings during the period, more than 90% as compared to other providers, with the next being in the low 80’s, followed by a big drop-off. This speaks to Bowne’s competitive edge, which should conservatively drive at least a 25% market share in this space. While filers only need to tag their financial statements in their first year of reporting, in the second year they will also need to complete detailed tagging for all of their notes which is far more complex and not easily automated. Bowne currently charges about $25,000/year for XBRL tagging, but that is likely to increase sharply as the tagging requirements become more exhaustive. Bowne estimates this should create an annual market opportunity of about $200 million by 2012. I estimate that Bowne should be able to capture about $5 million, $20 million, and $40 million in 2009-2011, respectively.
Marketing Communications (MC) – Shareholder services represents about a $2-$3 billion market, while MC is about $15 billion, which offers a nice opportunity for Bowne. Since 2007, Bowne has made three acquisitions to gain share. However, these acquisitions have resulted in hairy earnings reports as integration and restructuring charges have been necessary. As of 2008, MC accounted for 22% ($169 million) of Bowne’s revenues, yet management has commented that margins are currently thin as they have been developing this segment. In fact, gross margins from recent acquisitions were just 14% in 2008, versus over 30% for the rest of the company. Bowne should be able to leverage its infrastructure, spread its utilization of resources more efficiently, and pull from its existing client relationships and competency as an end-to-end service provider. However, this is an extremely competitive and fragmented space and I would like to see more evidence of profitability before suggesting that Bowne can realize significant value from this business. The segment suffered during the recession, losing about 10%-15% (half volume/half discontinued contracts with low-margin customers).
Cost Cutting – Bowne has restructured over the past few years, which should allow the company to realize meaningful operating leverage as capital markets activity rebounds and compliance requirements are extended. Indeed, Bowne states that it has removed about $100 million of annualized expenses since 2007. This includes a 30% headcount reduction, a consolidated real estate footprint from 21 print facilities to 9, increased outsourcing to India, a reengineered work flow, and process automation that will allow the company to take on more work without adding much more on the resource side. Since 4Q07, Bowne has cut its LTM SG&A to $177 million from $242 million. On the 3Q09 conference call, Bowne suggested that about 70% of this relates to the fixed cost base versus more impermanent declines such as salary cuts, overtime, or demand-driven outsourcing. In my base-case, I assume that SG&A cuts will bottom in 2009, then pick up modestly as financial transactions rebound. Specifically, I estimate that for each incremental $1 million in revenue, Bowne will assume an increase of $100,000 in SG&A. COGS savings also were realized, which should help gross margins and Bowne’s revised operating structure should allow it to unlock significant operating leverage as transaction activity moves forward through the cycle.
Balance Sheet Restructured – In August, Bowne completed a secondary equity offering of 12 million common shares, which raised about $72 million. This capital was used to pay down term loans in full and reduce the amount outstanding on the revolver. Bowne reduced total debt to about $35 million from $114 million and from 3.5x LTM EBITDA to 1x. Although the offering was dilutive to existing shareholders, who were understandably displeased, this removes liquidity concerns and financial risk that was an overhang on the stock.
Opportunities – Beyond the near-term horizon, there are future regulatory initiatives, which I have not included in my assumptions, but do provide a margin of safety around revenue and earnings estimates. These include more clarity on XBRL requirements for investment management firms, and disclosure mandates for hedge funds and municipal securities. All of this is difficult to quantify, but would allow Bowne to further leverage its infrastructure.
Risks – 1) I will keep an eye on the trend in restructuring charges (a result of severance and integration costs). Given the evolution of Bowne’s business and the recession, I am willing to give a pass for recent marks, but I would like to witness a pattern towards a more clean report going forward. Bowne has indicated that restructuring will drop to single-digits (millions) by next year, which would be welcomed. 2) A prolonged slump in capital markets activity would suppress the operating leverage that Bowne has built over the past few years. 3) If companies believe that they can tag financial statements in-house (XBRL), the revenue opportunity outlined above may be unattainable.