January 19, 2016 - 10:56pm EST by
2016 2017
Price: 40.83 EPS 0 0
Shares Out. (in M): 48 P/E 0 0
Market Cap (in $M): 1,948 P/FCF 0 0
Net Debt (in $M): -167 EBIT 0 0
TEV ($): 1,781 TEV/EBIT 0 0
Borrow Cost: General Collateral

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  • Accounting
  • Cyclical
  • Hardware
  • Leveraged Roll-Up Blow-Up
  • Acquisition
  • That was emotional
  • winner


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: