This company is currently in the final stage of a restructuring. The core segment is declining, but increasing profitability and a large share of recurring revenues makes high free cash flow generation for an extended period highly likely. Based on my assumptions, the market is valuing the company with a price to free cash flow multiple of 10x. In addition, the company invested in new segments which are currently not generating a profit. However, this might change in the future. Hence, an investor is getting the optionality of additional cash flow generation from these entities for free.
The core segment of Francotyp-Postalia (FP) contains the development, production and distribution of franking and inserting machines for the processing of physical letters. The majority of the revenue is generated with franking machines. Franking machines enable letters to be franked automatically. All franking machines need to be certified by the local postal authorities as they can be topped up with credit for the necessary postage. For instance, in the US, the largest market for franking machines, there are only five authorised suppliers by the US Postal Service. The even more interesting part of FP’s business model begins after leasing or selling the franking machines. The after-sales business with its recurring revenue streams generates a high share of the company’s total turnover. This includes the teleporto business (charge for topping up the machines with credit), the sale of consumables (tape or ink cartridges and customer-specific printing plates), the creation of printing plates, maintenance services and software solutions for cost centre management.
The market for franking machines is dominated by three competitors. Pitney Bowes is the world leader, Neopost has a leading position in Europe and FP is the leader in Germany and Austria with a market share of more than 40% in these two countries. Worldwide FP has provided 10% to a total installed base of 2.7 m franking machines.
Physical mail volume in secular decline
Until the late 90’s physical mail volume growth was linked to GDP growth. However, due to the rise of the internet and the resulting digitalisation of communication the physical letter seems now to be obsolescent in the worst case or to become a complimentary media to online in the best case.
Nevertheless, it is worth noting that worldwide business letter volume (excl C2C/C2B) has actually been pretty stable. Based on FP’s information, the volume of classical business mail has only declined by roughly 10% since 2004. Even more revealing is the situation in Germany. Total letter volume up to one kilo (incl C2C/C2B) has been fluctuating around 16 bn pieces per year since 1998. Reason for that seem to be the less severe recession in Germany after 2008 compared to other countries and the continued widespread use of business mail by the German Mittelstand and government authorities. However, the situation is quite different in the US were the recent recession accelerated the decline in physical mail volume. In this report, BCG expects total mail volume in France, Germany, UK, Italy and Spain (which are basically FP’s major markets) to decline by 3% per annum going forward. However, another recession in these markets could again accelerate the decline.
Large ongoing investments in the franking/inserting segment
Despite the negative outlook for the physical mail volume and the resulting implications for FP’s industry, the company is heavily investing in its distribution network and the installed base.
In Germany management is implementing a new sales channel besides its own distribution force by targeting associations. They have already won Büroring (350 independent dealers), WinWin Office Network (30 mid-sized dealers) as well as regional partners with a close contact to SMEs.
Due to an ongoing decertification process by the US Postal Service, FP is currently replacing 35,000 franking machines in the US which were installed in the early 90’s. This equals to 13% of all FP machines currently in use. The US is the most important foreign market for the company. Decertifications are performed by postal companies when older franking systems are to be replaced by a technologically new standard. The recent decertification is expected to run until the end of 2015.
Given that the US is a pure leasing market, the company needs to pre-finance these machines leading to a temporary increase in capital expenditures. An advantage of the leasing model is, that the company stays in close contact to their customers and can quickly react to additional/changing needs.
In addition, FP recently entered the French and Italian market. In Italy the company makes good progress with its leasing business. France is Europe’s largest market for franking machines and like the US a pure leasing market. FP is endeavouring to achieve a market share of 10% here in the medium term or roughly 26,000 franking machines. Neopost has a stronghold position in this market, which French La Poste would like to change. As a consequence, La Poste more or less invited FP to join the French market. FP is currently only marketing the small franking machine MyMail, but expects to receive certification in France for their successful product PostBase at the end of this year.
PostBase is an industry leading franking system which can be operated with a touchscreen or can be directly controlled via a PC and was introduced in 2012. It has already been certified in Germany, the US, Canada, Italy and the UK. PostBase is also part of the so called A-segment including small franking machines for the SME sector with a daily mail volume below 200 letters. This segment seems to be the most robust in the franking machine industry and it is also the most important for FP. So far Pitney Bowes and Neopost have not introduced a similar product like PostBase to the market.
Apart from broadening its footprint in traditional markets and constantly investing in new products, FP is simultaneously taking its first steps in markets such as Russia, Malaysia and India. These countries are still at the first stages of mail communication professionalization, meaning that the revenue and earnings effects will remain limited for the time being. In addition, the company faces challenges in setting up a distribution network and getting the necessary certifications in these markets. However, FP has taken timely possession of markets here, which could unfold considerable growth potential in the years to come. Last year they were quite successful in selling franking machines with a value of EUR 2 m to Russia.
Below you can find an overview how the different revenue components in the franking/inserting segment have developed over time:
The sales revenue of machines declined sharply during the recession and did not recover afterwards. This is in line with the statement I made above, that with each recession the decline rate in mail volume accelerates. In addition, the increase of smaller machines as percentage of unit sales and a larger number of machines leased are also reasons for the decline in sales revenue. At the same time, the company is generating roughly EUR 80 m of recurring revenue each year and this number has been more or less flat since 2007.
The relatively high profitability of the after sales business and the predictability of cash inflows makes this part of the business highly attractive despite the industry’s overall negative growth rate.
Transformation of the business model started in 2006
FP’s former management started to react to the liberalisation of the German postal market and to the shift of mail communication towards digital forms of mail processing shortly before FP’s IPO in 2006 with the acquisition of freesort (100%) and iab (51%).
With eight sorting centres throughout Germany, freesort is one of the leading independent consolidators of outbound business mail on the German market. Their mail consolidation services include collecting letters from clients, sorting them by postcode and delivering them in batches to a sorting office of Deutsche Post. Depending on the amount of letters consolidated, Deutsche Post is obliged to provide a discount on the postage of up to 36% to freesort. Over the last years revenues have continuously increased to EUR 43 m in 2013. However, competition in this market is extremely fierce. Though the company is not breaking out the freesort numbers individually, looking at the income statement it becomes obvious that material costs are increasing in line with revenue. Increases in revenue over the last years were mostly generated by freesort. So it seems that freesort has to pass on most of the discounts to the customers and is hardly able to generate profits at the moment.
iab is providing software solutions and services for the processing of hybrid mail. Hybrid mail refers to a blend of electronic and physical mail. The sender dispatches the letter digitally. The recipient gets a normal letter. iab takes on the entire production process in between, from printing out, franking and inserting to handover of the letter to a mail delivery company. Since the letter is sent digitally, customers are saved the expense of paper, envelope and printer, and also the costs of travelling to the post office or letterbox. The benefits of traditional letters are nevertheless still there. Revenues in this segment have grown steadily and reached EUR 13 m in 2013. Based on the company’s information, this segment is profitable.
Restructuring and turnaround after the recession
In 2006/2007, the former management paid an acquisition price of EUR 19.6 m for freesort and EUR 7.1 m for iab. As things turned out this was much too high and substantial write offs followed in the years afterwards. In addition, a period of sluggish operating performance in the core segment and relatively high fluctuation in management followed until the end of 2010, when the current CEO, Hans Szymanski, took over. A brief interview (in German) with Mr. Szymanski can be found here. Since then, the management focused on cost cutting, increasing efficiency and new product development. At the beginning of 2012, the company issued 1.46 m shares for EUR 2.66 each to the private investor Klaus Röhrig. Since then he has been the largest shareholder, holding 10.3% of the company and he became chairman of the board in April 2013. In addition to that, another eleven investors hold 43% of the company including Scherzer & Co. AG which is holding roughly 3.0% of the shares outstanding.
The most recent acquisition followed in 2011 with Mentana-Claimsoft GmbH (since 2014 FP is holding a 100% share) for roughly EUR 2 m. The company specialises in electronic signatures and, in addition to products for long-term archiving, also offers products for securing electronic documents and aiding legally binding communication.
Apart from that, Mentana-Claimsoft is one out of three accredited De-Mail providers in Germany. This fully electronic solution enables customers to send their letters securely and confidentially. What makes De-Mail binding is that both sender and recipient must identify themselves on first registering before they can use the technology. Confidentiality is guaranteed thanks to powerful encryption. The German De-Mail Act defines the security requirements, establishing the legal basis to ensure that the De-Mail has the same legal effect as a standard letter. It also places a stronger obligation on authorities to enable electronic communication with citizens. Essentially, the act governs aspects including the administration’s duty to open an electronic channel and the Federal Administration’s duty to open up access to De-Mail.
The two other accredited providers are United Internet and T-Systems (a subsidiary of Deutsche Telekom). While they focus on private customers, Mentana-Claimsoft is targeting corporate clients (e.g. government entities and insurance companies). For instance, Mentana-Claimsoft has won a mandate to implement the gateways and to operate the De-Mail system for Deutsche Rentenversicherung. However, it turns out that it will take quite some time until De-Mail will work as a substitute for physical mails for these type of large governmental institutions:
First, it seems to be quite difficult to change processes and IT. Second, currently Deutsche Rentenversicherung (German governmental pension fund) is not allowed to send mail via De-Mail. Hence, legislators have to adapt legislation.
At the moment Mentana-Claimsoft is not generating substantial revenues. Management is expecting that in three to five years, some 10% of De-Mail-capable mail potential in Germany will be sent via De-Mail. This corresponds to a quantity of around 540 million consignments. The company targets a market share of 10% of the De-Mail market, that is to say around 50 m consignments per year. This again could lead to a revenue contribution of EUR 15 m to EUR 20 m. Based on the latest annual report, strongly increasing margins are expected. EBITDA in percentage from revenue is expected to range between 16.2% and 42.5%.
FP positioned as multi-channel mail service company
The central element of the company’s strategy in Germany is the dovetailing of the different business segments. For instance, FP can approach existing freesort customers about the possibilities of using De-Mail and therefore open up a broader potential market for these solutions.
Another example is the new product PostBase Gateway Multi, which helps to overcome the time lag in the transformation to De-Mail. The system enables clients to use one type of software for De-Mail and hybrid mail. If the communication partner has a De-Mail address, the message is sent via De-Mail (Mentana-Claimsoft). If the communication partner does not have a De-Mail address yet, the message is sent via the hybrid channel (iab).
As a consequence, FP offers the entire letter post distribution chain today from franking and inserting physical letters through mail consolidation to hybrid and fully electronic mail dispatch via De-Mail.
In 2005 the former management and Quadriga Capital bought FP from Röchling Group. As a consequence of the leveraged buyout, the company had to take on a substantial debt load and pension liabilities relating to FP.
At the end of 2006, FP went public at an IPO price of EUR 19.0. The net proceeds from a capital increase were used to finance the acquisitions of freesort and iab and to repay part of the loans. In the following years the amortisation of intangibles and the impairment of goodwill weighted heavily on the income statement. Free cash flow was almost entirely used to repay debt. The recession following the financial crisis revealed weaknesses of FP’s operations and the new management had to undertake significant restructurings and cost cuttings afterwards.
For instance, the assembling of all machines was shifted and centralized in a new plant in Wittenberge (Eastern Germany). As a consequence, personnel expenses slightly declined (only 10% of the workforce are employed in production), but more importantly efficiency in production increased substantially. In addition, FP cancelled the membership in the Employers’ Association of the Metal and Electronic Industry. This gives more flexibility for future negotiations regarding salary increases. Management was also quite successful in reducing working capital needs.
Apart from the completion of the necessary restructurings in 2012, a new long term financing led by Deutsche Postbank was agreed on in 2013 at improved terms compared to the former financing. The financing facility has a maturity of up to 5 years and a total volume of EUR 45 m. In accordance with the loan contract FP must adhere to the following covenants:
The interest coverage ratio or the EBITDA divided by the financing cost must be at least 2.5 (10.7x YE2013). In addition, net debt to EBITDA must not be above 2.25 (1.77x YE 2013, but substantially improved in 2014). It is also not permitted to fall short of time-staggered, adjusted equity and equity ratios (no details stated in the annual report).
Despite the achievements mentioned, the balance sheet is still looking weak. The current equity ratio stands at 18.3%. Even worse, a large part of equity is still made up of goodwill and intangibles. In addition, though the company has no defined benefit plans in place, it is carrying a legacy liability in the form of pension liabilities in an amount of EUR 14.1 m. Due to a reassessment of former restricted cash in UK relating to the teleporto business net debt was reduced to EUR 11.0 m in 2014. Management already announced that a large part of the total available liquidity of EUR 31.3 m will be used to reduce the outstanding bank debt.
As already noted, for FP leasing is becoming more important compared to the sale of machines. In Austria the company is using finance leases to rent their machines. However, overall operating leases play a major role, which are used in the international business predominantly in the US. This mixed use of operating and finance leases provides for complexity in analysing the financials (in particular the income statement). The following table tries to overcome these difficulties by focusing on the cash conversion of FP’s business:
As already mentioned above, revenues in the franking/inserting segment are falling mostly due to the retreating sales business. freesort and iab show accelerated top line growth. However, there are two isues to be pointed out:
First, the large revenue increases in 2010/2011 for freesort and 2011 for iab are mostly due to changes in revenue recognition. Second, gross profit was not positively affected by freesort’s and iab’s revenue growth indicating that these two business entities together combined with Mentana-Claimsoft have not earned money for the company yet.
On the way from EBIT to operating cash flow, we can see the huge impairments from 2006 until 2010 (resulting from the two acquisitions and the leveraged buyout). Income taxes paid declined and the company has quite substantial loss carry forwards to be used in the future. Apart from that, I have included an additional line called “Inflow from finance leases”. The company reports this cash flow stream in the financing section of the cash flow statement. From an analytical perspective it makes more sense to add these cash streams to the operating section. Operating cash flow is very stable with the exception of 2011, when restructuring expenses spiked.
FP is capitalizing part of the R&D expenses. That’s not good, because it distorts the income statement. The company is constantly investing in new product development. Currently it focuses on a successor of the small franking machine MyMail and the De-Email technology. Investments in leases are currently at an elevated level due to the ongoing replacement process in the US which will last until 2015. New leasing business is and will be generated in France and Italy, which should lead to growing cash inflow from recurring revenues in the future. However, overall investment in leases are expected to fall after 2015. Free cash flow to the firm (FCFF) will be negative in 2014. Alongside the high investment activity, the relocation of headquarter to Berlin in autumn 2014 and the integration of the distribution departments in the Netherlands and Belgium causes the high cash outflow. Management estimates the positive effect of the relocation and the optimization of the international operations to be EUR 1.5 m per annum. Overall, as can be seen from the past there is vast potential for cash flow generation once investment outflow will revert.
In the past free cash flow was used to repay debt. Given that net debt has come down substantially it can be expected that equity holders will participate to a larger extent in the cash flow generation in the future (e.g. free cash flow to equity holders (FCFE) should increase). In addition, as a large part of the freed up cash might be used to further reduce the debt outstanding, interest paid on bank debt should fall in the coming years.
The current number of shares outstanding is 15.8 m. Based on a current share price of EUR 4.0 the equity value is EUR 63.2 m. Add to this net debt of EUR 11.0 m and pension liabilities of EUR 14.1 m and we get an enterprise value of EUR 88.3 m. Management is targeting an EBIT of EUR 12 m for 2014 and EUR 14 m for 2015. This translates into a modest valuation with an EV/EBIT multiple of 7.4x for 2014 and 6.3x for 2015.
What kind of cash flows can equity holders expect? The company should be able to generate EUR 21 m of normalized operating cash flow going forward. Stable recurring revenues, ongoing cost cuttings and new leasing revenue from France and Italy should help to hold this level for an extended period of time. Regarding investment activity, I assume that investment cash outflows will revert to historic averages after 2014 due to the reasons mentioned above. This translates in an annual investment activity of EUR 13 m. Assuming that management makes use of the large cash pile to reduce debt, interest payments will further decrease. Let’s suppose that they will use EUR 15.0 m or 48% of the current cash balance. As a result, debt outstanding will be down by 36% to EUR 27.2 m. Based on the numbers for the first six months of 2014 we can extrapolate interest payments and make the assumption that interest payments at the current debt level sum up to EUR 2.5 m. Reducing the interest payments by 36% leads to EUR 1.6 per annum.
Putting this all together, I believe that free cash flow to equity holders will approach EUR 6.4 m after 2014. Based on this assumption, the company is currently valued with a P/FCFE of 9.9x or a free cash flow yield of 10.1%.
In my analysis I came to the conclusion that freesort, iab and Mentana-Claimsoft are currently hardly breaking even if viewed as a combined entity. This implies two consequences:
First, my valuation does only concern FP’s franking/inserting business. Given that the industry is in secular decline, the estimated free cash flow yield is going to be reduced by a negative growth rate. If we assume that free cash flow declines by 2% per annum, we will still get an attractive 8% yield.
Second, I have not given any value to freesort, iab and Mentana-Claimsoft. In its annual report the company is performing a detailed impairment test for the three companies by estimating the fair value less cost to sell. The valuation is derived from a DCF-Model. freesort is valued with EUR 21.9 m (WACC:10.2%; growth rate: 2%), iab based on a 51% share with EUR 3.9 m (11.5%, 2%) and Mentana-Claimsoft with EUR 16.0 m (16.3%, 2%). This sums up to an additional value of EUR 41.8 m for the group.
Of course, this is just a rough indication and based on the subjective estimates of management. However, from my perspective an investor is currently not paying for a future contribution to cash flows from these entities. At the same time, I expect the core business to generate ample free cashflow in the upcoming years.
FP’s management seems to make a good job to enhance profitability of the franking/inserting segment. Though this segment is positioned in a declining industry, good cash flow generation and a high share of recurring revenues make the business quite stable. A low quality balance sheet, high historic losses on the income statement and uncertainty regarding the decline rate of the old business and the potential profit generation of the new business seem to hold down the company’s market value at the moment. However, I expect profitability and free cash flow generation to improve substantially over the next three years. With this expectation, today I am only paying for the old business and get the optionality for the new business for free. Apart from that, a broad range of financial investor’s is holding the equity component. In addition, the company is listed at the “Prime Standard” of Deutsche Börse. Hence, I regard the delisting risk with its negative consequences for minority holders based on German law to be low.
In my last post, I announced that I will start to accumulate a position in FP. Based on the assumption that I trade one third of the daily volume, I bought a 3% position for the virtual portfolio at a VWAP of EUR 4.14 from August 28th to September 2nd.
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