ELECTRONICS FOR IMAGING INC EFII
October 07, 2015 - 2:03pm EST by
runner
2015 2016
Price: 45.42 EPS 0 0
Shares Out. (in M): 48 P/E 0 0
Market Cap (in $M): 2,180 P/FCF 0 0
Net Debt (in $M): -320 EBIT 0 0
TEV ($): 1,860 TEV/EBIT 0 0

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Description

 

Thesis Summary:

At the current price EFII offers an attractive opportunity to invest in a high quality industrial printing business serving diverse and growing end markets, with attractive recurring revenue streams, high incremental margins, and generating significant free cash flows. EFII will have an overcapitalized balance sheet with ~$6+/share or ~15% of market cap in net cash at the end of 2016. Ex-cash, EFII is trading at <14x 2016 EPS, on my estimates. While not stupidly cheap, I believe that EFII can organically compound earnings at ~20% over the next few years, which makes it attractive in the current choppy market.

 

Their July 2015 investor presentation http://ir.efi.com/events.cfm and the associated transcript might help provide an overview of the end markets, the business segments and 2 recent acquisitions, which will help contextualize this thesis better.

 

Historically (1995-2005), EFII primarily sold Fiery- a digital front end (DFE) or controller for industrial printers, which contributed nearly half the revenue and 60% of gross profit until 2010. This meant EFII was an obscure B2B business with heavy reliance on OEMs such as Xerox, Canon, Ricoh, Konica, Kyocera, Sharp etc., which offer Fiery as a performance option on their printer installed base. This also meant EFII’s growth largely followed the product refresh cycles of these OEMs.

 

After a series of acquisitions and healthy growth in the inkjet and productivity software segments over the past 5+ years, today EFII’s business looks much more balanced:

  • 48% of revenue from Inkjet printers (30% from digital inkjet printers and 18% from inks and consumables) sold to four end markets: a) Display Graphics b) Textiles c) Ceramic tiles d) Labels & Packaging.

  • 35% from Fiery

  • 16% from Productivity Software

With its full ecosystem of hardware and software for print, EFII is uniquely positioned to monetize the transformation of print from analog to digital. It has a dominant position in the end markets it currently addresses with a lot of headroom for growth given that most print markets are only 5-35% digital. EFII has been able to grow ahead of its underlying markets through market share gains, cross selling of its products and accretive acquisitions (The individual segment economics is elaborated following the thesis summary).

 

For 2016 in particular, management's guidance as well as street's earnings estimates appear low because EFII is yet to provide full visibility into the opportunities and synergies accruing from 2 recent acquisitions (Reggiani and Matan) made on July 1 2015. It is worth noting that management left their 2016 EPS guidance of $2.45-$2.60 unchanged despite acquiring ~$80-100M of annual revenue through these acquisitions. The reason they cited is that they needed a full quarter as a combined company to help determine how much revenue and earnings they can actually recognize under US GAAP, given that Reggiani is based in Italy and Matan in Israel. I expect them to provide more clarity during the investor day in Nov 2015, which serves as a near term catalyst.

 

Based on my estimates, with the entry into the textile printing market (Reggiani acquisition) and the addition of lower end industrial printers (Matan acquisition), EFII could compound earnings at 20% and grow EPS to ~$4+ in 2018 from ~$2+ in 2015. By 2018, they would have accrued $9.50+ of net cash on the balance sheet. Keeping the multiple where it is today, at 18x 2018 EPS the stock could be worth $72. Alternately, valued at 14x 2018 EPS + $9.50 of net cash, it could be worth $68 in <3 years. This is consistent with EFII’s historical multiple and does not make this thesis dependent on a huge multiple expansion. However, one could argue that EFII would command a significantly higher multiple as an acquisition target, to reflect EFII’s competitive position, high growth, recurring revenue, and superior cash flow conversion characteristics. Also note that I don’t give any credit here for accretive use of cash or borrowing capacity, which would command more value than the 1x multiple I ascribe to cash.

 

Business Description:

EFII has three main businesses:

 

Inkjet:  Inkjet products comprising of printers, inks and maintenance services that cater to high-growth markets such as:

  • Display Graphics - TAM of $1.4Bn growing at 8-10% and 35-40% digital today

  • Textiles - TAM of ~$800M growing at 20%+ and ~5% digital today

  • Ceramics  - TAM of $700M growing at 20%+ and 35% digital today

  • Labels – TAM of $700M, poised to grow at 20+% and less than 10% digital today

Printer sales are non-recurring in nature, whereas ink sales and services are recurring. Thinking about margins, this is a classic razor razor-blade model where the inks have much higher profitability and incremental margins compared to the printers.

 

Fiery: A Digital Front End (DFE) that integrates hardware and software to transform printers into networked printers. EFII has ~65% share of the $500M+ TAM which is growing at 3-4%. Fiery has been growing at 8-10%, driven by market share gains and selling higher priced Fierys for technologically advanced printers. EFII could potentially command 75% of the existing market over the next ~3 years.

 

However, EFII's partners (Landa, Ricoh etc.) are expected to introduce a new class of printers in 2016 for large volume page printing (as opposed to display graphics which is most of the current TAM for EFII).  These printers will address the 90% of pages which are still printed in analog. Because of this shift in focus by partners, EFII will be able to sell higher priced at much higher margins. This appears to be an attractive opportunity, which could increase the TAM to $600M from $500M+ today.  Although Fiery sales are non-recurring in nature, the quality of the business is poised to improve with the higher priced offering and associated expansion in margins. Hence it is not unreasonable to expect Fiery to continue to grow at ~8% with some price-driven upside to their historical 67-69% gross margin.

Productivity Software: This segment includes productivity software products for printing. This market is highly fragmented with TAM of $900M growing at 5-7%. EFII’s software segment has been growing ~8% organically. They supplement it with 3-4 acquisitions per year resulting in 10-15% growth for the software segment. I don’t see a reason why the 8% organic growth is not sustainable for a few years, given that a lot of the growth likely comes from cross-selling to their current installed base of printers. It is also worth noting that EFII has been investing in this segment, so margins could be higher as they achieve scale, which is not something I incorporate into my numbers today.

 

The most noteworthy aspects of the thesis are:

The transformation of the business away from Fiery:

  • If the business develops as I anticipate, recurring revenues would grow to 37% in 2018 from ~29% in 2015

  • Inkjet would contribute 60% of revenue (with roughly 50:50 printers: ink+ other consumables) and 45% of Gross Profit by 2018, up from 49% of revenue and 35% of gross profit in 2015, driven by:

    • continued double digit growth in UV ink for industrial printers

    • growth in newly launched Creta ink for ceramic printers from EFII’s installed base, with the opportunity to expand to competitors’ installed base over time

    • increased attach rates in ink for textile printers from a low rate of ~40% today

    • cross-selling of textile printing technology and inks to existing industrial inkjet customers for soft signage which is an area of demand unaddressed by EFII today

    • high growth and consequent increase in lower end industrial printer and ink market share through the Matan acquisition

    • cost synergies and improvement in margins from switching Matan and Reggiani to in-house manufacturing for inks from their current outsourced model

  • By 2018, Fiery would be far less significant, at 28% of revenue and 38% of Gross Profit, down from 34% of revenue and 44% of Gross Margin in 2015. This is a desirable outcome because the material proportion of Fiery in the total business is an impediment to a competitor such as HP viewing EFII as an attractive acquisition target as Fiery is a direct competitor to its own controller/DFE.

  • Overall operating margin improvement of ~50-100bps/year driven by:

    • Ink sales, which has higher incremental margins, outpacing printer sales

    • selling higher priced Fiery to cater to higher end printers as well as cross selling Fiery to customers obtained through acquisitions; note that Fiery has the highest margins (~70% gross margin) within EFII’s offerings

    • gradual reduction in software investments, once they build enough scale through a combination of organic growth and acquisitions

 

The business offers a lot of headroom for growth in the medium-long term because:

  • Today, print markets are only 5-35% digital; the TAM would be $32Bn at 100% digital conversion and EFII’s offerings currently have only ~$12Bn TAM (at 100% digital conversion), leaving several large and rapidly growing unaddressed markets such as Packaging ($5Bn), Corrugated ($9Bn), Folding Cartons ($3Bn) etc.

  • EFII is uniquely positioned with products to address the full ecosystem of printers, ink, software and Fiery- a digital front end compatible with any printer, unlike competitors who typically offer only printers and ink and proprietary front ends only for their own printers. This allows EFII much higher cross sell opportunities when they acquire smaller companies and also makes them the most attractive buyer in the market for smaller printer companies, as evidenced by the Reggiani acquisition described below.

 

For 2016 in particular, management's guidance as well as street's earnings estimates appear low because:

  • Their guidance likely does not capture the full run rate revenue from the recent acquisitions in Italy and Israel, as they are unsure how much revenue they will be able to recognize under US GAAP and will have clarity after one full quarter as a combined company. The current guidance for 2016 of $2.45-$2.60 appears much lower than my estimate of $2.85 with the transactions baked in. Hopefully we will get a better clarity during their investor day in November, when they elaborate on the opportunities within textiles and lower end segment of industrial printers.

  • The magnitude of synergies is not well understood. Today Reggiani sells primarily to the fashion industry. The key revenue synergies are (i) cross selling of Reggiani's printer/technology to existing customers for soft signage printing, which EFII's customers were asking for even before this transaction and (ii) new applications for Reggiani's water based inks (iii) manufacturing of Regianni and Matan inks in-house, versus outsourced manufacturing today. It does not seem unreasonable to expect that the textile segment to have higher than the average growth rate of industrial printers over 2016-2018.

  • Importantly, it is worth noting that Reggiani insisted on taking stock instead of an all cash deal, likely because they believe that EFII's ecosystem offers significant growth potential for the textile business. This also demonstrates that EFII management believes that the stock is undervalued today and adds credibility to my synergy/growth expectations. Secondly, ~40% of the total value of the transaction is in earnouts over 2015-2017, so the Reggiani management remains committed to the business even after the sale.

 

Capital Allocation: Lastly, I remain confident in management’s capital allocation abilities, with the recent acquisitions adding to their long track record of accretive M&A. I also believe the cash build-up on the balance sheet will begin to abate and ROE would improve in the medium term, given their commentary on the strong acquisition pipeline. However, it is worth noting that HP could get more aggressive after its reorganization, which suggests that increased competition in the print sector could be a tail risk. Also, the management seems constitutionally averse to having a large net debt position despite the recurring nature of its business model, which is not the most optimal or shareholder friendly capital structure.

 

Exit Strategy: Given the high recurring revenue and free cash flow, EFII would ideally be an attractive acquisition candidate for a larger print/industrial player. The big hurdle to such a transaction today is the large proportion of Fiery in the overall business, given that an HP or Xerox, if they were to acquire EFII, would be unable to sell Fiery to its competitors. One option could be to spin out Fiery or sell it to Private Equity before (or as part of) such a transaction. Alternately a large diversified company such as Danaher or Dover, who would not face such issues, could emerge as an acquirer.

 

Risks:

  • Growth is dependent on a healthy global macroeconomic environment, although EFII has been gaining market share and operates in smaller niches compared to its large competitors such as HP, Xerox, Ricoh etc.

  • Currency is a risk for the inkjet and software segments, something I have not tried to project

  • HP could get more aggressive post its reorganization as described earlier, making the competitive landscape and less favorable and acquisition targets more expensive

  • Although I have not modeled out acquisitions explicitly, it is a part of the EFII’s historical and future strategy. So the risk of overpaying for acquisitions and/or integration risk and/or failed acquisitions will always exist, despite the decent capital allocation track record

 

The following table outlines EFII’s earnings profile ($ Millions except per share data):

Earnings Profile for EFII

2013A

2014A

2015E

2016E

2017E

2018E

Revenue

           

Fiery

255

281

306

330

357

385

% growth

 

10%

9%

8%

8%

8%

Software

118

131

141

152

165

178

% growth

 

10%

8%

8%

8%

8%

Printers

235

239

256

273

296

319

% growth

 

1%

7%

7%

9%

8%

Inks +other recurring

119

141

169

225

290

369

% growth

 

18%

20%

33%

29%

27%

Organic Revenue

728

790

872

980

1,108

1,251

% growth

 

9%

10%

12%

13%

13%

Inorganic Revenue

           

Regianni (Textile inkjet)

   

37

91

107

124

Matan (Lower end industrial inkjet)

   

3

7

12

17

Total Inorganic Revenue

   

40

99

118

141

             

Total Revenue

728

790

912

1,079

1,227

1,393

% growth

 

9%

15%

18%

14%

14%

             

EBIT

2013A

2014A

2015E

2016E

2017E

2018E

Fiery

69

81

92

103

115

128

% margin

27%

29%

30%

31%

32%

33%

Software

17

21

24

27

31

35

% margin

14%

16%

17%

18%

19%

20%

Printers

29

29

31

34

36

39

% margin

12%

12%

12%

12%

12%

12%

Inks +other recurring

31

39

48

63

82

106

% margin

26%

28%

28%

28%

28%

29%

Total Segment EBIT

146

169

195

226

264

308

% margin

20%

21%

22%

23%

24%

25%

% incremental margin

 

36%

31%

29%

29%

31%

Unallocated operating expenses

48

54

60

67

76

85

% revenue

7%

7%

7%

7%

7%

7%

Organic EBIT

98

115

135

159

188

222

% margin

14%

15%

16%

16%

17%

18%

% incremental margin

 

27%

24%

22%

23%

24%

Inorganic EBIT

           

Regianni (Textile inkjet)

     

10

14

18

Matan (Lower end industrial inkjet)

     

1.2

2.3

3.6

Inorganic EBIT

   

0

12

17

22

% margin

     

12%

14%

16%

Total EBIT

   

134

169

203

242

% margin

     

16%

16%

17%

             

EPS

2013A

2014A

2015E

2016E

2017E

2018E

EPS (ex-currency)

$1.59

$1.82

$2.22

$2.85

$3.46

$4.17

% growth

 

15%

22%

28%

21%

21%

Currency impact

   

($0.11)

     

EPS

   

$2.11

$2.85

$3.46

$4.17

             

Diluted Shares

48.4

47.9

47.9

47.5

46.9

46.6

 

The following table outlines EFII’s business transformation as described above ($ Millions except per share data):

Table 2: Business Transformation

 

2013A

2014A

2015E

2016P

2017P

2018P

% of Organic Revenue

             

Recurring

 

26%

28%

29%

32%

35%

38%

Non-Recurring

 

74%

72%

71%

68%

65%

62%

Total

 

100%

100%

100%

100%

100%

100%

               

% of Organic Revenue

             

Printers (hardware)

 

32%

30%

29%

28%

27%

25%

Ink + other recurring

 

16%

18%

19%

23%

26%

30%

Inkjet

 

49%

48%

49%

51%

53%

55%

Fiery

 

35%

35%

35%

34%

32%

31%

Software

 

16%

17%

16%

16%

15%

14%

Total

 

100%

100%

100%

100%

100%

100%

               

% of segment EBIT

             

Printers (hardware)

 

20%

17%

16%

15%

14%

13%

Ink + other recurring

 

21%

23%

24%

28%

31%

35%

Inkjet

 

41%

40%

41%

43%

45%

47%

Fiery

 

47%

48%

47%

45%

44%

41%

Software

 

12%

12%

12%

12%

12%

11%

Total

 

100%

100%

100%

100%

100%

100%

 

The following table outlines EFII’s FCF profile and capital allocation (2012A-2018P, $ Millions except per share data):

Free Cash Flow for EFII

Note

2012A

2013A

2014A

2015E

2016P

2017P

2018P

Sources

               

Net Income

 

61

77

87

112

132

157

187

Depreciation & Amortization

 

8

8

10

10

10

10

(Increase) Decrease in working capital

 

26

(13)

(32)

(7)

(13)

(10)

Deferred Taxes

 

(53)

52

(9)

0

0

0

0

Other

 

0

0

0

0

0

0

0

Total

 

43

124

57

115

129

157

185

Uses

               

Capital expenditure

 

6

50

16

15

15

15

15

Required debt repayment

 

0

0

0

0

0

0

0

Dividends

 

0

0

0

0

0

0

0

Other

 

0

0

0

0

0

0

0

Total

 

6

50

16

15

15

15

15

FCF

 

37

75

41

100

114

142

170

FCF/share

 

$0.78

$1.54

$0.85

$2.08

$2.41

$3.02

$3.65

FCF conversion

 

60%

97%

47%

89%

87%

90%

91%

                 

Acquisitions/earn-outs

 

(62)

(15)

(22)

(143)

(22)

(22)

0

Dispositions

 

184

0.4

0

0

0

0

0

                 

Debt raised

   

0

285

5

 

0

 

Equity/Warrants issued

 

19

12

51

31

     

Share repurchases

A

(35)

(36)

(101)

(61)

(50)

(75)

(75)

                 

Beginning Cash

   

365

355

617

542

586

636

FCF

 

144

37

253

(75)

44

50

103

Ending Cash

   

402

608

542

586

636

739

                 

Share Repurchases

A

     

(61)

(50)

(75)

(75)

Repurchase price

       

$42

$42

$54

$66

Shares repurchased

       

(1.4)

(1.2)

(1.4)

(1.1)

Offset for dilution from stock options

     

(0.7)

(0.8)

(0.7)

Reduction in FDSO

         

(0.5)

(0.6)

(0.3)

Notes

A: Share repurchases: As of 08/04/2015 they have $99M remaining share repurchase authorization, to be completed by Nov 2016. ~40% of the repurchased shares will actually shrink the cap, while the rest will offset dilution from stock options

 

The following table outlines EFII’s balance sheet ($ Millions except per share data):

Balance Sheet for EFII

Note

2012A

2013A

2014A

2015E

2016P

2017P

2018P

Cash & CE

 

365

355

617

542

586

636

739

Cash/share

 

$7.65

$7.34

$12.88

$11.31

$12.35

$13.56

$15.86

                 

Debt

 

0

0

285

290

290

290

290

Debt/share

 

$0.00

$0.00

$5.95

$6.05

$6.11

$6.18

$6.22

                 

Net (Debt) Cash

 

365

355

332

252

297

346

449

Net (Debt) Cash/share

 

$7.65

$7.34

$6.93

$5.26

$6.25

$7.38

$9.64

                 

Equity

 

651

767

789

865

951

1,038

1,158

Equity/share

 

$13.63

$15.87

$16.47

$18.05

$20.04

$22.14

$24.86

                 

Net Debt/EBITDA

         

-1.5x

-1.5x

-1.6x


Note: EFII is up to $46+ from $42.50 when I started writing this thesis. The price of procrastination!

I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise hold a material investment in the issuer's securities.

Catalyst

Investory Day - Nov 2015

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