November 19, 2010 - 10:01pm EST by
2010 2011
Price: 44.92 EPS $3.05 $3.15
Shares Out. (in M): 12 P/E 14.7x 14.2x
Market Cap (in $M): 527 P/FCF 6.0x 5.6x
Net Debt (in $M): 147 EBIT 63 66
TEV ($): 693 TEV/EBIT 11.0x 10.5x

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According to Wikipedia, "cognitive dissonance is an uncomfortable feeling caused by holding conflicting ideas simultaneously." And cognitive dissonance explains the story behind the Consolidated Graphics (CGX) investment thesis.

CGX is the 9th largest printing company in the U.S., with a focus on short-run, commercial printing. CGX is an amalgamation of 70 different printing companies with complementary capabilities that have been consolidated under the leadership of Joe Davis over the past 25 years.

Why is this opportunity available?

• The printing industry is out of favor.
• The printing industry is out of favor.
• The printing industry is out of favor.
Well, then, why did Joe Davis, the CEO and founder, who has built this company up since 1985, buy $13m of stock, when he already owned almost 15% of the company (taking his total ownership to 17%). Doesn't he know that the printing industry is out of favor? Let's see what everybody knows about the printing industry:

Conventional Wisdom about the Printing Industry

• Declining revenues due to a secular shift to digital forms of media.
• Low free cash flow from highly levered companies and high capital expenditure needs.
• No pricing power.
• Commodity product.
• Dinosaur-like management teams

Let's take each of these and evaluate their relevance to CGX.

Declining Revenues:
Since 2007, aggregate printing shipments declined by 15% in 2008 and 2009 as companies pulled back on advertising and marketing and reassessed their strategies. Even after the economy recovered somewhat, the secular shift away from print has continued. However, stabilization has occurred since then; in fact, U.S. printing shipment growth has been positive in the aggregate since the end of 2009.

CGX revenues declined sharply during the downturn, as one of their largest companies serves mostly clients who sell luxury goods, automobiles, and financial services, not a good combination for the period from September 2008 to June 2009. Since then, however, CGX has seen improving results in its same-store sales.

Furthermore, in the short run, CGX will benefit from $12m of election-related revenues in the upcoming quarter (FQ3 2011) as well as about $50m of annualized revenues from acquisitions that were made in the past six months.

  FY2007 FY2008 FY2009 FY2010 FQ1 2011 FQ2 2011
Same-store sales (excl. election) 5% -1% -9% -13% 2% -1%
Election-related 3% -1% 2% -11% 2% 2%
Acquisitions 6% 11% 12% 0% 1% 3%
Total 14% 9% 5% -24% 5% 4%

Low free cash flow from highly levered companies and high capital expenditure needs:

This may true for the industry, but there is an emerging split between the haves and have-nots in the printing industry. According to the Census Bureau there has been a dramatic shift between larger printing companies and smaller printing companies over the past two years. As can be seen in the data below, while the industry is 25% smaller now than two years ago, it is still split roughly 50-50 between small companies (assets below $25m) and larger companies (assets above $25m). However, whereas two years ago the EBITDA margin was similar and the smaller companies had a better balance sheet (1.3x Net debt/EBITDA), today the situation is reversed. Now, the larger companies have EBITDA margins almost twice those of their smaller competitors, and their leverage ratio has shrunk while the smaller companies' leverage ratio has ballooned to 3.1x EBITDA.

LTM March 31, 2010    
  Total Printing Industry Under $25m Over $25m   CGX ($687m of assets)
Revenues $61,416 $30,940 $30,476   $991
EBITDA % 10% 7% 13%   11%
Net debt $20,901 $6,316 $14,581   $175
Net debt/EBITDA 3.5x 3.1x 3.7x   1.6x
LTM March 31, 2010    
  Total Printing Industry Under $25m Over $25m   CGX ($834m of assets)
Revenues $80,808 $41,241 $39,567   $1,095
EBITDA % 10% 10% 10%   14%
Net debt $22,865 $5,324 $17,541   $371
Net debt/EBITDA 2.8x 1.3x 4.3x   2.5x
Source:  Census Bureau

Another way to see this is through the recent consolidation in the space. In addition to some of the big ones, like Quad/Graphics' merger with World Color and RR Donneley's takeover (in process) of Bowne, there have been 294 printing industry transactions since January 2008, according to CapitalIQ's database. Of those, 132 have been bankruptcies.

The lending environment for these companies is not helping either. Even though the corporate lending markets are much improved now since last year, according to a recent Printing Industries of America report, only 4% of commercial printing companies surveyed described working capital loans as "easier to obtain" in Q210 vs. Q209.

Despite all the consolidation and bankruptcies, this is a still a significantly fragmented market. The top 400 printers account for about 35% of the market.

CGX is in a great position to pick up business from weakened competitors. Their operating structure is a major asset in the current environment. Each of their 70 companies has its own "President" and its own brand name (which sometimes has a local or regional reputation that goes back for 50+ years). Each President is judged and compensated based on his company's own P&L (plus incentives for cross-selling with sister companies), so they have the entrepreneurial spirit of a small company with the resources and capital of a large company.

Overall CGX, is a well-run business. During the downturn the Presidents focused hard on costs, and despite the operating leverage working against them, they minimized the impact to operating margins, which never went negative. Now that the business has stabilized, they are beginning to see improvement.

  FQ109 FQ209 FQ309 FQ409 FQ110 FQ210 FQ310 FQ410 FQ111 FQ211
Same-store sales (excl. election) -3.9% -1.7% -9.4% -21.4% -19.3% -13.2% -6.8% -4.0% 2.3% -1.2%
EBIT Margin 7.0% 7.1% 7.5% 1.9% 0.4% 3.7% 7.9% 3.9% 3.7% 6.2%

Also, CGX has a strong focus on free cash flow, with an LTM FCF yield of 14% (after adjusting for a one-time litigation settlement payment in the latest quarter). Their FCF yield is helped by modest leverage and a very low interest rate.

Another way to look at CGX performance is to compare their revenue growth (excluding election-related revenues) to the growth of the overall printing industry. They outperformed every year, with the exception of 2008, when they were hit by the disaster in auto, financial services, and luxury goods.

While CGX's large competitors are buying large, healthy companies for full valuations, CGX picks off small tuck-in acquisitions in value-creating ways. For example, in June, CGX purchased the Hickory Group, which was a $35m revenue business in financial distress due to an overextended owner and an aggressive bank. CGX was able to buy the assets of the business (and customer relationships) for $3.3m, or roughly 65% of AR under 90 days, 50% of book inventory, plus the fair market value of their equipment. Once CGX was able to transfer one of its Presidents to take over and implement their purchasing synergies, it didn't take long for Hickory to pay for itself.

Commodity products:
Conventional wisdom is that commercial printers create undifferentiated products, but the rise of digital printing over the past several years has added to the schism in the industry described above. Older companies that either don't have the inclination, expertise, or capital to invest in digital equipment will not be able to survive in a new environment.

With its strong balance sheet, CGX has invested heavily in digital printing since 2007, and now they have the largest digital printing network in North America with over 220 high-speed digital presses. Digital printing is growing rapidly (21% in the latest quarter), and now represents 14% of their revenues. Their prowess in digital printing is how they have succeeded with their largest customer, Apple. CGX prints all of the photobooks that are ordered through Apple's website. In addition, Apple asked CGX to open up a plant in Prague in 2006 to speed distribution in Europe, and CGX is now exploring possibilities in Asia.

CGX is also progressing on an innovative program with Ford to create vehicle brochures that will be customized for each dealership. So instead of Ford ordering 100,000 brochures to sit in a warehouse until dealerships order them, dealerships can use a CGX-built intranet site to order exactly the quantity of brochures they need with the regionally-relevant cover photo they want. The digitally-printed cover matches up with the conventionally printed interior of the brochure.

But CGX's quality and reputation does not only apply to digital printing. They also have long-term, high-end clients like Tiffany, Lillian Vernon, and Ralph Lauren. In addition, they were selected by Disney to print a new (started in Spring 2009) limited-edition magazine for Disney enthusiasts called Disney 23. If you have a chance to see one of these magazines, you will realize that the printing industry is not simply about putting ink on paper.

With their 70 companies around the country (map here:, CGX has a complete spectrum of print needs from cards to catalogs to POP displays to mailers to flexible packaging. This "one-stop shop" has led to strategic, national accounts with multiple locations to represent 21% of total revenues, up from 14% in 2007. They are benefitting from vendor consolidation, as large corporations are suddenly finding that their aggregate printing costs across many geographies are worth diving into. CGX can help them reduce their overall printing costs.

Dinosaur management teams:
Common perception is that since the printing industry is in secular decline, their management teams must be as well. Joe Davis, CGX's CEO and Founder, may be 67, but he is young at heart and has not lost any of his drive. The son of a farmer/entrepreneur in Arkansas, he bought his first printing company in 1985 after working for 15 years in accounting at Arthur Andersen.

On April 1, 2010, Joe Davis reported that he owned 14.6% of CGX stock (including soon-exercisable options). On May 11, he increased his stake by 11% (at ~$38) and then on August 26, he increased his stake by another 7% (at ~$37.50). He now reports that he owns 17.4%. It is not every day that you see $13m of open-market purchases by the CEO of a $500m market cap company over the period of three months. Joe seemed to know what he was doing when he bought $4m in stock in October 2008 and $3m in March 2009 (average price around $11.25).

If Joe's stock purchases did not convince you, maybe you will appreciate that CGX just renegotiated its credit agreement to build in flexibility for stock repurchases and authorized a $50m buyback program (about 9% of shares outstanding). In the past, CGX has been aggressive with repurchases - in 2007-2008, CGX spent $175m buying back its own stock. I think we will see something similar in the near future.

Joe runs the business like the owner that he is. He is detail-oriented and demanding. He is CGX's capital allocator, serving as a banker for the 70 companies. It is valuable, too, that he started in this industry by buying distressed printing businesses throughout Texas in the mid-1980s, when Texas was suffering from the aftermath of a banking crisis, housing bubble, and declining commodity prices. In short, he knows how to operate in today's environment.

Joe learned how to recruit and build an organization from Arthur Andersen. CGX's human resources model is a key differentiator, and mimics the recruiting processes of consulting, banking, and accounting firms. For the past 15 years, CGX's companies have been recruiting intelligent students from good universities in their regions, and they train the recruits in all aspects of the business in a 3-year program. Currently, 30% of their company presidents have come out of their leadership development program (including at least one under 30-years old). The homegrown talent brings the company several benefits: (a) strong connections among the various companies, which helps in cross-selling; (b) a youthful orientation towards trends in digital media and how it can be integrated into print; (c) the internal competition that comes from such an "up or out" culture that is surprising to find in such an industry.

I believe that a base case for CGX in a couple of years will reflect ~60% stock appreciation, while an upside case could at least double the stock price. For a downside case, I see 5-15% potential declines (and likely only temporarily). Given the company's track record, management team, industry dynamics, and very strong "hints" by the CEO through his aggressive purchases and announce stock buyback, I believe that the base and upside cases are much more likely and present a favorable overall risk/reward.

A lot still has to go right for CGX with acquisitions, capacity, vendor consolidation, etc, but I believe that all the elements are in place. If the upside occurs, my assumed EBITDA multiple of 6.5x is not heroic by any means. From 2004 to 2008, CGX traded above 8x EBITDA.

In determining valuation for CGX, I look at three scenarios into FY2013 (which ends 3/31/2013):

Base Case: "Continued positive trajectory; modest economic recovery"
• Strategic sales increase to 6% for all of 2012 and 8% for 2013.
• Election revenues for 2012 are flat with 2010 (non-election year); for 2013 are down 10% vs. 2009 (presidential year). This accounts for a continued slow decline in print usage.
• Rest of the business is up 3% (based on acquisitions and organic growth)
• Assumes that 65% of EBITDA is converted into FCF (range from 2004 has been between 21% and 118% with an average of 63%) and that 40% of the FCF is used for share repurchases.
• 2013 EV/EBITDA multiple of 5.5

In this scenario, the stock price would be $73.

Upside Case: "Accelerated strategic sales; somewhat better economic recovery"
• Strategic sales increase to 10% for all of 2012 and 10% for 2013.
• Election revenues for 2012 are flat with 2010 (non-election year); for 2013 are down 5% vs. 2009 (presidential year) - to reflect reduction in print usage between now and then.
• Rest of the business is up 4% (based on acquisitions and organic growth)
• Assumes that 65% of EBITDA is converted into FCF and that 65% of the FCF is used for share repurchases. Excess cash goes on the balance sheet.
• EV/EBITDA multiple of 6.5

In this scenario, the stock price would be $90.

Downside Case: "Progress with strategic sales, but swimming upstream against the industry"
• Strategic sales increase to 5% for all of 2012 and 5% for 2013.
• Election revenues for 2012 are flat with 2010 (non-election year); for 2013 they are down 15% vs. 2009 (presidential year) - to reflect reduction in print usage between now and then.
• Rest of the business is down 5% with acquisitions likely offset by organic revenue declines.
• Assumes that 65% of EBITDA is converted into FCF but zero used for stock repurchases.
• EV/EBITDA multiple of 4

In this scenario, the stock price would be $48. 

• The shift to digital continues to bring down all competitors -- but capacity continues to come out of the system as weak competitors file for bankruptcy.
• Execution issues ... but CGX has a reputation in the industry as a high-quality operator, and underperforming company presidents will not last long under Joe Davis.
• Apple drops them as a vendor -- but CGX is the only printer who currently serves Apple, and CGX has been growing with Apple for over 5 years.


• Additional acquisitions of low-cost distressed companies (good companies, bad balance sheets).
• Strategic sales growth.
• International expansion.
• Active buy back program dramatically reduces the number of shares outstanding.
• Strong FQ3 (CQ4) revenues and margin expansion as a result of strong photobook sales.
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