Valassis Communications (VCI) is a market leader in the coupon insert and advertising industry. The company pioneered the free-standing insert flyer back in the early 1970s which has gone on to become common place today in newspapers and mail packages. In recent years the company has gotten cheaper and cheaper and garnered a lot of short interest, as the market believes that the secular shift towards more digital advertising mediums will eventually put the nail in the coffin for companies such as Valassis. However when you look a bit deeper here it is evident that the growth trends are not really that negative in the core business at all, and meanwhile Valassis is continuing to pay down debt and generate lots of cash. With no love for the company, I think Valassis is one catalyst away from a big pop in price and it is a compelling value play today.
Investment Thesis Summary
My thesis for Valassis consists of the following points:
Long Term Growth is still expected to be Positive - Despite what the headlines say, the long term prospects for standard mail (mostly ads) is actually not that bad with even some slight growth expected in the coming decade. In addition to this, Valassis is growing in both digital and in-store retail markets, which will allow the company to continue growing revenues at single digit rates.
Shareholder Friendly - The company started paying a generous dividend yielding around 5% in the past year, which is a sign of confidence in the business going forward. In addition to this about 20% of outstanding shares have been repurchases in the past 4 years, and the company is on pace to continue retiring nearly 5% per annum with ample amounts of free cash flow.
Margin of Safety is Compelling - With strong free cash flow growth continuing, the company should be worth as much as $50/share, double the current market price. Continued buybacks coupled with the dividend make the downside risk minimal as well, meaning that patient investors should be well rewarded if any positive catalyst should come to fruition in the next year.
Business Overview
The business of Valassis is centered around advertising and marketing, providing over 15,000 advertisers services to allow them to target consumers. The core business is centered around Shared Mail, where the company states it provides the only national shared distribution network with the ability to reach 9 out of 10 US households. In total the company has 4 major business segments with revenues of $2.1B in 2012. The table below taken from a recent investor presentation in May 2013 show the breakdown per segment for Q1 2013 as well as the full year 2012.
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A few important points to note here, which give an understanding of the current dynamics of the business. Firstly, the Shared Mail segment accounts for about 62% of revenues and almost all of operating profits. This business basically consists of bundled advertisements which are wrapped in plastic or other packaging and shipped to target customers via standard USPS mail services. Although the revenues have declined slightly quarter over quarter, they have been relatively flat the past few years and are up actually about 4% since 2010, as seen in the 2012 annual report. Free-Standing Inserts, or FSI, made up about 13% of revenues in 2012. These inserts are mostly in the form of coupon books which the company prints and distributes. This business has been doing very well lately, with revenues up an impressive 12% quarter over quarter. The business is also very profitable, with an operating profit of over $11m in Q1, a 105% increase from a year earlier.
The other segment of the business seeing significant growth is the International, Digital & Media Services, or IDMS. As stated in the Q1 conference call by management, revenues in Digital alone were up 88% year over year, and the entire IDMS segment saw growth around of around 10%, also seeing significant growth in the in-store business. The weakest part of Valassis has been the Neighborhood Targeted segment, which is seeing significant competitive pressures coupled with the continued decline in newspaper circulation. The conversion of gross revenues from several larger clients to a net fee basis has led the decline in this segment. Although significant revenue declines coupled with operating losses are expected to continue, management has stated the segment still has value as it provides the opportunity to shift newspaper inserts into shared mail.
State of the Market and Future Opportunities
After looking at Valassis for a few minutes and understanding what the business does, it becomes obvious quite quickly why the company trades for a P/E of only 8.6. This is despite the fact that the business produces respectable free cash flow, has a dividend yield near 5%, and generates double digit returns on equity and capital. Quite simply, the continued shift to digital media and advertising as seen over the past 15 years with the rise of the internet has had a profound impact on companies like Valassis. Many investors are skeptical of the company's long term viability with its over reliance on physical mail inserts, in a time when US postal volumes are in a steady decline, and online shopping, advertising and even mobile ads continue to growth at astounding rates; Internet ad revenue was up 12% in Q4 of 2012 while mobile ads were up more than 100% year over year.
There is however one main flaw to this argument that is often overlooked on first glance. Although the total volume of postal mail is in decline, the volume of standard class mail - primarily advertisements like the ones distributed by Valassis, is not. A study done a few years ago by the Boston Consultancy Group for the USPS predicts that the volume of standard mail will remain relatively steady, and even see slow growth between now and 2020:
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Notice that the volume of standard mail will rise from an estimated 83B pieces in 2010 to 86B in 2020. The entire decline in overall mail volume is driven by sharp decreases in first class mail, which consists mainly of bills and personal letters -- two items which are now frequently done by digital means via online banking and email. The value of physical advertising flyers is still evident today and expected to remain that way for sometime, as the ROI remains higher than broadcast and newsprint. So although there is no big growth here to be excited about, there also is no major decline, and with strong execution Valassis should be able to keep its core shared mail business intact. This will continue to churn off ample free cash flow, and serve as a bedrock for further growth in the FSI, Digital and in-store sales segments.
Recent Company Results
Looking at the short term and recent results specifically, Valassis did not have a good Q1. The company reported lower than expected revenues in Shared Mail, and management decided to significantly revise 2013 guidance downwards to $3.05 - $3.20/share from the previous $3.50. This included a decline in EBITDA estimate of about $20m. As a result the stock has dipped back down to about $24, where a few months ago it was pushing $30. Although the short term future will remain uncertain as to whether the company can have a better 2nd half of 2013, management seems confident of the longer term. Management has also executed well in the past 5 years, as debt has been significantly reduced from $1.2B in 2007 all the way to $565m in 2012. Also what I like here is the company's consistent record towards shareholders. The company has bought back significant amounts of stock since 2008, reducing the share count by more than 20%. The company also instituted a quarterly dividend of $0.31/share for the first time in Q4 2012, which amounts to an impressive yield near 5%. Between dividends and stock repurchases the company is now returning around 60% of free cash flow to shareholders. With single digit revenue growth expected longer term (flat to low single digits in Shared Mail, double digits in FSI & Digital), the company should continue to pay down debt and grow free cash flow, and I see the short term difficulties as more of an opportunity rather than part of a bigger problem.
Current Valuation
Valassis has generated $3.40/share in free cash flow over the last 12 months. The company has been able to grow FCF at 15% per annum over both the past 5 and 10 year periods. With continued reductions in debt and share repurchases it wouldn't be surprising to see this rate of growth continue. Even if you assume a slower rate of 10%, the company seems significantly undervalued. Discounting this growth at 12% and I model a fair value of just under $50/share. Note that the few analysts who cover the stock seem to agree with my assessment, or even find it too conservative, as they have 5 year projected growth rates of more than 25%.
On an EV/EBITDA basis, the company is trading just under 6 which is near the bottom of its 10 year range and seems to be too cheap. Although the valuation has hovered in this region for the past few years, the fact that the company continues to reduce debt, buy back shares, and now pays a large dividend all seem to warrant a much higher multiple than might have been justified just 2 years ago. Note that competitor wise the company doesn't really have any good publicly traded comparables, so a relative valuation is quite difficult to do. News Corp (NWS) is a large competitor in FSI, and big internet companies such as Google (GOOG) and Yahoo! (YHOO) compete with the digital ad segment including Brand.net, but for obvious reasons those companies have many different dynamics which are not relevant to compare to Valassis.
Overall I think the valuation is intriguing, and Valassis could be a very interesting value play because of it. Even if you think $50/share is too optimistic, I can see the company easily moving up to the $30-35/range which is still a margin of safety of nearly 30%.
Key Catalysts for 2013-2014
The continued use of share buybacks, steady overall business and low valuation probably put a good damper on the downside risk for Valassis, however the stock is not likely to move significantly higher without major catalysts. The good news is I do see a few recent events which could indicate some positive catalysts for shareholders, if any one of them comes to pass.
Takeover or Privatization? - There are no definitive transactions known here, but I wouldn't be surprised to see something big, either a takeover or going private deal. Back in December during an investor conference, one analyst asked if the company would consider a private equity deal in light of its improving financial situation, growing earnings and yet a continued fall in share price of about 30% in recent years. Management stated at the time they would be open to anything which increased shareholder value. Recently in April, the company filed an 8-K where it was revealed that all top executives now have change in control agreements, CICs, which dictate terms about their compensation packages should the company enter into a definitive agreement. Management was asked about in the Q1 conference call a few weeks later, and they responded not to read anything into it, only that it was a standard practice in the industry that they had determined was a good idea to follow. Much of the executive team of Valassis are seasoned veterans both at the company and in the industry, so the timing does raise some suspicions in my mind, as to why the found this important to do now when they hadn't done it already years ago.
RedPlum Spree - Valassis will roll out it's new Spree service in a test mode, starting in Q2. Announced about 6 months ago, the new service will be sent on Fridays by direct mail and include weekend specials and coupons. The service is essentially directly targeting the standard inserts that are common in Sunday newspapers. With the continuing decline in newspaper circulation, Valassis has cut favorable deals with the USPS where it can earn postage discounts if it can increase circulation above 1 million pieces per year. The main difference from Spree and the standard RedPlum service is that it widens the target consumer base by focusing on circulars from department stores, home improvement stores, etc., rather than the typical grocery coupon insert packages. If successful, this could prove to be a further catalyst for growth into more verticals and propel the in-store business to continue growing at double digit rates.
Potential Short Squeeze - No doubt due to the perceived secular headwinds in the traditional paper-based advertising industry, the short sellers have jumped on the bandwagon and teamed up against Valassis. The company has a whopping 36% of its share float sold short. With over 9m shares short and an average daily trading volume of only about 400k, it would take more than 23 days to cover. The situation is very similar here to Pitney Bowes (PBI), another company heavily dependent on the traditional mail industry. For those who don't follow Pitney, the company also has a big short float, and about 6 months ago the company announced results that beat analysts expectations showing the decline in mail volumes was less than expected at the time. The result was a huge run up in share price in a few days, and the company is still up about 40% from lows at the end of last year. Of course there are many differences in the case of Valassis, one important one being stronger competition in its core market. However the company is still a market leader in shared mail advertising and does control an impressive 2% of of the entire volume of the USPS. Now is a good time to by into the company as it has had disappointing results over the past few months and the shares are more out of favor. Any positive earnings surprise should be a great catalyst for a nice pop in share price.
Key Investment Risks
Debt to Equity Remains Above 1 - Generally I don't like companies with high amounts of debt. Valassis has been improving its debt situation significantly over the past 5 years, and I don't think this is as big a risk as it was before. However the company does still carry a substaintial amount, about 120% equity over $580m. This is 5x greater than its cash balance. The good news is that the company is throwing off lots of free cash flow, more than $150m annually, and the fact that the company recently instituted a healthy dividend with a yield close to 5% is a signal that it has become much healthier financially. At the current rate the company is paying out close to $50m in dividends annually, but is also able to buyback close to that amount in stock, or nearly 5% of outstanding shares. This still leaves ample cash remaining to pay down debt and cover interest, so in reality the company seems to be in no near risk of financial trouble, as long as its cash cow shared mail business can hold a relatively flat line or produce modest growth.
Increased Competition - Particularly in the FSI and Digital businesses, competition has been increasing in recent years. The company's main competitor in FSIs is News America, a subsidiary of The News Corp which is a substantially larger company with greater resources. During 2011 and 2012 Valassis admits to losing market share in the FSI segment, and in addition pricing pressures have caused margins to be lower. Also in the digital segment, although revenues have been growing at more than 80% year over year, they still make up only about 5% of total revenues, and the companies Brand.net is competing directly with much larger internet companies such as Google. The risk here therefore is primarily around margin pressure and slower than expected growth, which if this materializes it would make a long term investment in Valassis much less attractive as the Shared Mail segment is expected to be largely flat over the coming decade.
Increased cost of Raw Materials - The primary raw material for a company like Valassis is paper. In fact the company had $31m in raw materials listed in inventory at the end of 2012 most of which is paper products. Through 2013 the company has an agreement with a large paper producer for 77% of its needed supply at a fixed price. The other 23% is bought from other suppliers at variable market rates. When the company goes to negotiate a new contract with the primary supplier at the end of this year, unfavorable raw material costs could impact guidance for 2014.
The Bottom Line
Valassis is a compelling value stock today. The company is a long standing market innovator and leader in the coupon and advertising industry that has come largely out of favor in recent years due to the perceived secular headwinds in the industry as more and more of their core business shifts online. When you look objectively at the company though, what you have is a very good business that generates a lot of cash and has quietly been shoring up its balance sheet, buying back stock, and also transforming part of its business to capture new growth markets in digital and in-store advertising. The market is not yet convinced, as the company trades at an EV/EBITDA level just below 6, despite having a clear path to double digit growth in FCF over the next several years. Even if the company continues to have lackluster results for the remainder of 2013, the continued repurchasing of shares coupled with an already cheap valuation is likely to put a solid floor on the stock. I would be surprised to see it re-test the lows of the past year around $20 share. On the upside, any positive surprise in earnings will likely cause a short squeeze and lead to significant increase in share price. Although the stock is seemingly a long way off from my fair value estimate near $50/share, I think north of $30/share is very achievable by year end. With a dividend yield close to 5% thrown in as a bonus, I really like the risk/reward profile on Valassis and I think it's a solid pick for any value oriented portfolio.
Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in VCI over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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