Description

I believe EFII is a very attractive short with meaningful downside. Fair value for the stock is in the low 20s (close to 50% downside) once investors see the company for what it is – a heavily-promoted stock with anemic organic growth and terrible quality of earnings led by a management team with a track record of value destruction so consistent that even Carly Fiorina would be impressed with it. Even if long investors do not “wake up” there is still meaningful downside to the high 20s (~30% downside) from deterioration in EFII’s end markets and a return to a more normal valuation range.

Here is the crux of the thesis:

1.       Over-optimistic growth story pumped up by a promotional mgmt team

2.       Opposite of a compounder – GAAP EPS has barely budged in 20 years

3.       Has meaningful risk in a global recessionary/slowdown environment

4.       Terrible quality of earnings, economic EPS is dramatically lower (~1/2 of non-GAAP EPS)

5.       Huge number of other red flags

Business Overview:

EFII has 3 segments: Industrial Inkjet (industrial-size printers and parts), Fiery (digital front ends “DFE” for commercial printers), and Productivity Software (business process, e-commerce solutions).

1)      Industrial Inkjet (52% of revenues; 35% of gross profit)

The Industrial Inkjet segment sells industrial-size digital inkjet printers, parts, and ink to commercial photo labs, large sign shops, graphic screen printers, specialty commercial printers and digital/billboard graphics providers through a direct sales force as well as select distributors. It is important to draw the distinction between digital and analog (also called offset) printing. You can see these processes in action here:

Offset printing: https://www.youtube.com/watch?v=RW1HJdW5XLs

Digital printing: https://www.youtube.com/watch?v=tSuJU7QF_Sk

The bull case on the stock largely revolves around the ongoing shift from analog to digital printing. While analog printing has cheaper per-unit costs, there are also significant batch costs (E.g. etching of printing plates) which makes short-run printing very expensive – in these applications, digital printing, where per-unit costs for the 1st and 1000th unit are the same, is attractive. According to mgmt, we are in the early stages of this shift:

The choice to print in digital or analog is also application specific – here are some of the core markets for EFII’s digital printers per mgmt:

In this segment, EFII competes against printers produced by Agfa, Domino, Durst, Canon, HP, Inca, Mimaki, Roland, and Mutoh. Notably, many/most of these players are Japanese so their relative competitiveness vs. EFII has improved over the last few years from the JPY devaluation.

2)   Fiery (34% of revenues; 46% of gross profit)

The Fiery segment sells digital front ends (“DFEs”) which provide a customer interface for digital copiers and printers (both office and commercial). Essentially, these are the touchscreens that you would have on your office printer to help select print options, manage queues, etc. Fiery is typically integrated into the design of commercial printers and is present both on EFII-produced printers as well as other companies that EFII has a relationship with like Canon, Epson, Xerox, Konica Minolta, Ricoh, Sharp, Toshiba, etc. They also sell self-service and payment solutions to FedEx Office, Staples, Canon, and college campuses & libraries. Their primary competition is from their own customers who can develop their own in-house DFEs, in terms of 3rd party developers of DFEs, Fiery is the largest.

3)      Productivity Software (14% of revenues; 20% of gross profit)

The Productivity Software segment sells software to a variety of printing operations (e.g. medium and large commercial print shops, in-plant operations, government operations, direct mail print shops, label and packaging industry, etc.) through a direct sales force. EFII sells a variety of software packages to help manage these printing operations, including automating printing processes, streamlining workflows, and e-commerce solutions. Competition for these products varies and would typically be from smaller niche software providers. EFII also faces competition from larger vendors such as HP, Epicor, SAP, Oracle, Solarsoft, and Heidelberg.

1. Over-optimistic growth story pumped up by a promotional mgmt team

EFII has been a persistent growth story. As mentioned, lately mgmt has been getting people excited with talk of the analog to digital conversion and how it will drive significant revenue growth – relevant targets from their investor day are as follows:

• Inkjet: 10-13% organic growth, 10-20% total

• Software:  7-9% organic growth, 10-20% total

• Fiery: GDP+ grower

Notably, these targets are not materially different than those given four years earlier in a similar investor day. The question is, has their performance justified these healthy growth expectations?

A cursory glance at their financial statements would imply that yes, they have achieved these growth expectations – there has been strong ~10% top-line growth over the last four years, in-line with guided performance. However, what mgmt is not so upfront about is the fact that this growth has been driven significantly by an endless series of small acquisitions – the vast majority of which are too small to be “material” but which in aggregate are a meaningful tailwind. Mgmt does not make stripping out these acquisitions easy, but it can be done using “Treadway” disclosure in their 10-Ks. After completing this exercise, we see that growth from 2011-2015E has significantly underperformed expectations, and is only getting worse:

• Consolidated: ~2.4% ex-acquisitions vs. 10.1% reported

• Industrial InkJet: ~4.5% ex-acquisitions vs. 16.5% reported

• Fiery: ~3.1% ex-acquisitions vs. 3.5% reported

• Productivity Software: ~(2.6%) ex-acquisitions vs. 13.2% reported

Note that the revenue growth ex-acquisitions has been declining and absent the Fiery segment would be negative. How does this square against this huge shift from analog to digital that mgmt is promising investors? The answer is that this shift has been occurring for some time now, and contrary to what mgmt would like investors to believe, the “inflection point” is not 2015, or 2016, or any point in the future, but rather is already behind us in ~2013.

The fact that the core business is barely growing absent historical acquisitions is troublesome for a story stock. And to be clear, this is exactly what EFII is – a look at the recent initiate from Barclay’s makes it clear that their buy recommendation is based entirely on the story rather than any valuation discipline:

“EFI is not a “cheap” stock but given the increasingly consistent and stable nature of the business model (more recurring revenue) we believe that a higher multiple can be supported. The shares trade at 14.4x our 2017E EPS; we see 18x as a reasonable fair value and set our PT at $52.” – Barclay’s, Jan 13 initiation

Not only are they applying an aggressive multiple here, but they are doing so to 2-year out earnings on an Adj. EPS number that dramatically exceeds the FCF generation potential of the business (see further discussion later).

It is also worth noting that the “recurring revenue” they speak of is primarily the software business which is only consistent in that it is consistently declining – this segment was called out as being particularly weak in Q3 and the VP of Americas Software Sales, a 16 year veteran, left in mid-Q3. Other than this segment, “recurring revenue” refers to the ~30-40% of InkJet segment sales which are for ink & recurring service contracts and which likely only make up ~15-25% of company profitability.

Looking at EFII’s historical stock chart going back to the mid 1990s, we can see that the company has traded on its story before – previous instances (1997, 2000, to a lesser extent 2008) have not worked out well:

2. Opposite of a compounder – GAAP EPS has barely budged in 20 years

Due to the variety of add-backs and very significant SBC, the cleanest way to do a long-dated period-over-period comparison for EFII is reported GAAP EPS. It is noteworthy that despite growing revenue by 20x, EPS is essentially the same as it was 5, 10, 15, and 20 years ago (note: no dividends were paid in the interim). The current CEO has presided over this company since 2000 and has been at the company since 1995 – returns to shareholders through his reign have been atrocious. The consistent destruction of capital is important – not only does it inform what “fair value” should be for the company, but it also provides additional margin of safety on the short. Unlike other “earnings manipulation” & “quality of earnings” shorts where time is on mgmt’s side (they can use their inflated stock to dig themselves out of trouble), with EFII time is clearly on the shorts side – even if the company can manipulate earnings forever and no one ever cares about their poor quality of earnings, mgmt’s poor performance means that you shouldn’t be too much worse than flat over the longer run.

3. Has meaningful risk in a global recessionary/slowdown environment

One misconception about EFII is that they are a “recurring revenue” play with protection in a recessionary/slowdown environment. This is plainly not the case – a chart of EFII’s TTM revenue going back 20 years illustrates that this business is very cyclical (peak-to-trough top-line declines of 35-40%) and that current LSD growth rates ex-acquisitions are also baking in a fair bit of “cyclical” growth (in other words, through-the-cycle growth rates are probably negative).

Looking at EFII in a global recessionary/slowdown environment is particularly important given their meaningful emerging/commodity markets exposure (China is ~10% of sales; Brazil, Australia are not immaterial). On their Q3 call mgmt went into quite a bit of detail on weakness in these markets, despite noting China as an area of strength on their Q2 call. These geographies are just beginning to weigh on results and recent economic data out of China suggest that this headwind will only increase in coming quarters, making it tougher for mgmt to hit their numbers.

“Growth in [Asia Pacific] would have been larger … had it not been for China, which saw a sequential decrease in revenue due to weakness in economic conditions. Revenue across all product lines declined in China in Q3.”

“I was at the epicenter of the China softness, which is the south part of China where a lot of the manufacturers are … in the middle of the quarter … And I would say that every business owner that I talked to were pretty downbeat about the current situation and at least the near-term opportunities. So that was the first time [I ever visited] China and got this kind of a negative sentiment.”

“Yes. It’s a sell-through issue. It’s just not – all of the channels are selling less this quarter than they have in prior quarters. And again, I wouldn’t call it a nose-dive per se, it’s definitely weaker than it was last year and weaker than it was in the prior quarter, but we’re still generating business in China.”

4. Terrible quality of earnings, economic EPS is dramatically lower (~1/2 of non-GAAP EPS)

EFII’s quality of earnings is absolutely atrocious. In the LTM period, mgmt reported non-GAAP EPS of $1.93 (putting us at a still-high 21x this number), but I believe “economic” EPS was only $0.89/sh, or 54% lower, and putting EFII at a nosebleed 46x earnings). Here is the bridge between these figures – most of these items should not be controversial and I do not believe I am being overly punitive:

• ($0.65) for $39M of recurring SBC (mgmt makes share buybacks to offset this, they are real cash expenses)

• ($0.19) for $12M of non-cash interest (mgmt only includes the cash portion of their 0.75% convertible notes, my number assumes similar non-convertible debt would cost ~4%)

• ($0.10) for $6M of constant acquisition & restructuring costs (there have been add-backs in each of these two categories in every single quarter going back until at least Q1 2011; the number I use is equivalent to the lowest TTM acquisition & restructuring costs ever recorded as a % of revenue over the last 4 years)

• ($0.10) for $5M in additional taxes (mgmt is using a depressed 19% non-GAAP tax rate – a more accurate figure appears to be something in the high 20s, I use 27%)

Not only is there an extremely large gap between mgmt’s non-GAAP EPS and “economic” EPS, the gap between these numbers has been widening over the last few years, implying that mgmt is on an “adjustments treadmill” that keeps going faster and faster:

5. Huge number of other red flags

Finally, there a huge number of other red flags that I uncovered when analyzing EFII – while none of these on their own suggest a smoking gun, taken together they add fuel to the short thesis:

A) Drawdown on warranty reserve

• Management has significant discretion in how much of a warranty reserve it holds against its products

• Drawing down on these reserves can serve to bolster EPS in a quick pinch to meet earnings estimates (note: the company has not missed earnings since Q2 2009 for reasons such as this)

• Management has consistently taken warranty reserves down to the point where they are now ~1/3 lower than they were 3 years ago:
  
  

• Further note that one of the largest drops in the reserve took place in Q4 2014, a quarter we are now lapping

• In that quarter, warranty provisions only amounted to 0.2% of sales rather than a more normal 1.5%, serving to boost margins by 130bps

B)  DSO moving higher

• Net DSOs have been moving higher, suggesting increasingly aggressive sales practices (note: dotted line is seasonally-adjusted)

• Note that over this same time period deferred revenue days and DPO have also been increasing which may imply that the DSO expansion is innocuous
  

C)  Dramatic jump in deferred cost of revenue

• Deferred cost of revenue signifies product that has been shipped to customers, but for which revenue has not been recognized yet

• Not sure exactly why this has skyrocketed in Q3 2015 but may suggest excess channel inventory (shipping unwanted product to customers)

• More innocuous explanation could be the two acquisitions completed in Q3 2015, but at only ~11% of consolidated revenue they should not have moved the needle this much
  

D) Curious use of factoring arrangements

• EFII has factored ~4% of their A/R since late 2012

• Most companies who use factoring do so for liquidity reasons – it can be a needed source of capital when others are exhausted

• EFII has had material net cash balances for essentially its entire existence and shouldn’t have any liquidity issues

• Therefore, the presence of factoring arrangements suggests one of two things: 1) Mgmt is using the arrangements to “smooth” cash flows and working capital balances, or 2) Their cash on hand is illusory or otherwise inaccessible

E)  Confusing convert deal in 2014

• I’ve already discussed the impact of the convert notes on the non-GAAP EPS

• However, the fact that the convert even exists is a bit odd – similar to the use of factoring arrangements, there does not appear to be a valid business use for this transaction

• Management has run with a meaningful net cash position for its entire existence, and when the convert was issued, EFII had $325M of cash & STI available, more than enough to run the business

• No meaningful deal was completed with the convert proceeds, nor was it used to invest significantly in the business

• Conspiracy theory would be that liquidity is not as significant as it appears to be (see factoring arrangement above)

F)  Constant GAAP gains from FMV adjustments on contingency payments

• EFII completes a lot of small deals, and as consideration for these deals they often structure a portion of the payment as earnouts (contingency payments) which have an estimated liability at the time of closing

• Changes in the estimate of this contingency payment flow through the GAAP income statement and have been a consistent tailwind (average benefit of $1.4M per quarter, or $0.02/sh)

• These items are backed out of non-GAAP EPS so are not a quality of earnings issue

• However, the fact that the estimated earnout payments to acquired companies decreases every quarter is inherently a sign that acquisitions are not performing as expected

G) Revolving door of CFOs

• While the CEO has been in charge since 2000, the CFO position has been a revolving door of people that only stay in the role for a few years before moving on to roles that do not appear to be meaningful steps upward:

• Marc Olin (current CFO since April 2015, was interim from January 2015)

• Previously was COO, SVP, General Manager

• David Reeder (CFO for 1 year: Jan 2014 to Jan 2015)

• Moved on to become CFO of Lexmark (LXK) – horizontal move, maybe small upgrade

• Was previously a divisional CFO at Cisco

• Left a couple of million in unvested RSUs, some of which were dependent on the company reaching $1B in revenue and $2.50 in non-GAAP EPS by 2016

• Vincent Pilette (CFO for 3 years: Jan 2011 to Sept 2013)

• Moved on to become CFO of Logitech – horizontal move

• Was previously VP finance at HP

• Left a couple million in unvested RSUs

• John Ritchie (CFO for 4 years: April 2006 to May 2010)

• Moved on to become CFO of Ubiquiti Networks – horizontal move

• Was previously VP finance at EFII

H) Non-GAAP tax games

• As mentioned above, mgmt is using what I believe to be a depressed non-GAAP tax rate of 19%

• What is more of a red flag is the fact that mgmt now seems to be backsolving for a tax rate rather than allowing mix and other intra-quarter events to naturally affect the tax rate (as it should given the international operations and other one-time factors)

• Not only has the effective non-GAAP tax rate come down over time (despite no obvious geographical mix shifts which should cause this), but it has been exactly 19.00% for the last 7 quarters which seems a bit suspicious:
  

Valuation

The valuation here could go in a number of directions.

“Head in the Sand” Valuation (Bull Case, $45-55):

Management has guided for non-GAAP EPS of $2.45-2.60/sh in 2016, and they have RSUs which kick in if they hit $2.50/sh in 2016 so those are two obvious anchors for next year. In the absence of a downturn in their markets, I’d expect EFII to trade at a multiple comparable to what it has in the last 3 years (even though the multiple has arguably been quite elevated in this time frame) which is ~20-23x LTM. This would put them at a $48-58/sh a year from now, or $45-55/sh discounted back to today.

“Top-line Headwinds” Valuation (Base Case, $26-32):

Another option is that EFII’s end-markets deteriorate or are expected to deteriorate. The last time this happened, valuation re-rated to ~12-15x forward P/E. Under a low organic growth scenario (in-line with my base expectations, 2016 EPS on mgmt’s definition should be ~$2.15/sh – at 12-15x this would reflect a $26-32/sh valuation.

“Economic” Valuation (Bear Case, $21-23)

The case here would be that investors wake up (through a well-publicized short report or otherwise) and realize what the economic earnings power of the business truly is. My 2016E on an economic EPS basis is $1.07/sh – on a low-teens multiple reflecting a business with GDP-like growth trends but with a mgmt team that has consistently destroyed capital, (say 10-12x), this would be worth $11-13/sh plus another $10/sh in excess cash. The multiple could be even worse if we see a cyclical downturn as well (last time this happened sales declined 35-40%...)

Risks

• Big risk is that mgmt continues to game the EPS with impunity and that no one cares

• Mgmt has guided to $2.45-2.60/sh for 2016 which seems very difficult to hit without aggressive gaming

• However, they have some RSUs (worth ~$1.5M) which only kick-in if $1B in revenue and $2.50 in EPS are hit by Q4 2016, so I’m sure they’ll try to find a way

• Have lots of excess cash, will be heavily incented to do deals, particular because it is “free” accretion

• This could be an easy way to hit 2016 targets – buy something big for $500M

• Theoretically, EFII could be an acquisition target (as can almost any company). While there are lots of large dinosaurs that could be interested in buying “growth”, EFII has been an independent public entity for ~24 years now, and the CEO appears to be a megalomaniac intent on running the business, so it’s begs the question “why now”?

Catalyst

Unfortunately I don’t believe that EFII is likely to miss in Q4, or in any quarter until they are forced to by top-line weakness. My best guess for how things turn out from a fundamental perspective is that mgmt reports an in-line Q4 but with increasing red flags in working capital & reserve balances, and that they announce a material acquisition with their cash on balance sheet in the next few months that allows them to hit their 2016 revenue ($1b) and adj. EPS ($2.45-2.60) targets. Meanwhile quality of earnings will continue to decline for those investors who care and mgmt will continue to destroy capital. At 46x “economic” earnings and top-line concerns I think you are paid to wait here, but I don’t profess to know when this one cracks.