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21st Century Gutenberg or the Anti-Tablet, Anti-Cloud Investment
With the advent of personal global positioning systems to replace printed directions, “Cloud” applications for sharing photos electronically, and iPads for reading just about anything in your arm chair, consumer printing volume has been in a nose dive. The data is gruesome. According to IDC, page volumes for inkjet printers (a reasonable proxy for the consumer) have decreased from 37 billion pages in 2005 to 10 billion in 2010. That is a 23% decrease per year! So, ever the contrarians, we bought shares in a printer company.
In 2010, Lexmark (LXK) produced $4.2 billion in revenue and $360 million in free cash flow (excluding an acquisition). The company ended the first quarter of 2011 with $1.3 billion in cash and marketable securities and only $650 million in long-term debt for a net cash position of $650 million. At $30/share, the market cap is $2.3 billion or $1.65 billion net of cash. Even if we haircut 2010 free cash flow to $300 million, we get a free cash flow yield of 18%.
We think the market is focused on the deterioration of the consumer printing business and the fact that LXK’s top line has been shrinking. What the market seems to be ignoring is the bottom line results LXK has managed through the transition away from consumer printing and the fact that they are six months from being fully transitioned out of that business. Unlike consumer printing, enterprise printing is fairly stable in the US and growing in emerging markets – empirical data shows this was the case during and coming out of the recession. As alarming as the data around consumer page volumes is, the data around enterprise printing is equally reassuring. Page volume for standalone laser printers began to shrink in the low single digits starting in 2008 as the recession took hold. Low single digit shrinkage occurred for multi function inkjet and monochrome laser printers as well. On the other hand, multi function color laser printer page volume has been growing at a robust pace: 37% in 2008, 21% in 2009, and 15% in 2010. Page volume is a critical measure because it not only indicates people and businesses are still buying printers, but more importantly in LXK’s case, it measures demand for ink. Their business model is classic razor and blade and 70% of their revenues come from ink. In addition, the move toward color laser has further benefit as these printer cartridges are more expensive and higher margin.
We do not have page volume estimates for emerging markets, but we do know that after growing a modest 2% in 2008 and then shrinking 17% in 2009, laser hardware sales were up 34% in 2010 to a record high 23 million units. To top it off, cash flow is incredibly stable – LXK has generated over $400mm in earnings before interest, taxes, depreciation, and amortization (EBITDA) for each of the last 9 years (including the recession), despite the fact that they have been in a multi-year transition away from the consumer business.
While not likely able to grow at the same rate, from a capital structure standpoint, the company looks a lot like Microsoft (MSFT), only amplified. If we were running the show, we would issue an additional $550 million in debt and buy back $1.2 billion in stock. A stable business like this can easily withstand 3x debt to EBITDA. With a new market capitalization of $1.1 billion, we would put in place a $110 million dividend; around a 35% payout ratio. We suspect the stock would trade to a 4-5% yield or $60/share. Distinct from MSFT, this business is the perfect size for a leveraged buyout. If management will not fix the capital structure, maybe someone else will. “Hello, Carlyle, KKR, and Blackstone. Are you listening?”
Rolling the Dice in the People’s Republic
Prior to 1988, a gambler in the United States had two choices if she wanted to play table games or slot machines: Las Vegas or Atlantic City. However, in that year, the Indian Gaming Regulatory Act kicked off a wave of casino expansion throughout the United States. Today, thirty-eight states have some form of casino gaming. For much of this period, the demand for gaming product outstripped the legally controlled supply of gaming options. This supply/demand imbalance allowed just about anyone with a gaming license to generate a nice profit. The best operators were able to do extraordinarily well. A savvy investor was able to take advantage of this growth industry and supply/demand imbalance without needing to learn casino operations or acquire the lobbying expertise necessary to gain state gaming licenses. For example, if you had purchased shares in the Penn National Gaming (PENN) IPO on May 26, 1994 you would have compounded your money at a 25% annual rate through December 31, 2010. This is extraordinary and we challenge you to find another single security that was able to provide that level of return over that long a period.
The US market is becoming saturated. Profits, while still quite strong, are not what they used to be. We cannot go back in time, but we can apply Mark Twain’s famous aphorism: “history doesn’t repeat itself, but it does rhyme.” We think it’s 1994 for gaming in Asia (and more specifically China). Las Vegas Sands (LVS) is smack-dab in the middle of it.
At $44/share, LVS trades at a free cash flow yield of 5.6% even after we haircut current EBITDA margins to slightly above 2009 trough levels. The back of the envelope math works like this: $8 billion in run-rate revenue and an average EBITDA margin of 34% yields $2.7 billion in EBITDA; subtracting $300 million for interest payments, $215 million for maintenance capital expense, $185 million for taxes leaves $2 billion in free cash flow to equity. Divide by 811 million shares and you get free cash flow per share of $2.47 or a 5.6% yield. This is an impressive yield for a company that has grown revenue at 31% annually for the last five years and is very profitable.
As mentioned above, we think gaming is set to continue its explosion in Asia. The only new supply coming online in Macau over the next few years will come from LVS. A large, 6,000-room project will open in early 2012 on Parcels 5 & 6 of the Cotai Strip. A smaller project on Parcel 3 could open as early as 2013. Just the Parcel 5 & 6 project could easily add another percent or two to LVS’ free cash flow yield at $44/share. Equally important, revenue at existing properties is likely to continue to rise given how underserved Asia is. There are plenty of statistics to illustrate this, but one that sticks out is the fact that only 2% of the total population of China and Southeast Asia visit Macau or Singapore in a year whereas 10% of the U.S. population visits Las Vegas. We’re ready to roll the dice on LVS; the odds appear in our favor.
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http://valueinvestorcanada.blogspot.com/
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