Media Sciences International, MSII
January 07, 2007 - 11:42am EST by
2007 2008
Price: 5.98 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 68 P/FCF
Net Debt (in $M): 0 EBIT 0 0

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MSII has doubled since I recommended it here a year ago. Even so, the progress the company has made on many fronts since that report has convinced me that MSII is a plausible four bagger over the next several years from this level, possibly a good bit more; hence a new write-up.  I realize that is an inflammatory appreciation claim to make to a conservative VIC audience, but I will attempt to justify it.
MSII makes replacement cartridges that go into certain name brand color laser and color solid ink printers.  MSII is not involved with ink jet printers, the kind most people have at home, because the cartridge business for that is lower margin, with numerous competitors selling ink refills or remanufactured cartridges.  MSII’s business, despite its present small scale and some inefficiency in its production of color toner cartridges, reported gross margins of 55% last quarter.
Ink jet printers are very cheap to buy and excellent for photos, but the text quality isn’t great, the speed is slow, and the cost per page is very high.  Laser and solid ink printers cost more initially, but  offer superior text appearance, high speed operation, lower cost per page (although still above monochrome), and good quality color for the graphs and charts likely to be in a business document.  So most of the printers for which MSII makes cartridges are used in offices.
Not counting a few Asian counterfeiters, MSII has its niche pretty much to itself to date.  This is because it is very hard to design and produce a cartridge that works right, gives good color output, doesn’t violate the patents of the printer companies, and can be made and sold at a substantial discount to the name brands’ products.  There are a few remanufacturers of color cartridges for laser printers, but the quality difference between new and remanufactured cartridges is much greater with color than monochrome.  In addition, the remanufacturers focus mainly on high volume HP laser printers, where there are enough used cartridges available to get volume efficiencies, while MSII so far makes cartridges only for printers made by Xerox, Epson, Dell, Brother, Okidata, and some others.  These companies sell a lower volume than HP, but price their cartridges much higher.
The various printer companies all work on a classic razor/razorblade model—they have very low margins on the printers themselves, but outrageous margins on the cartridges—gross margins appear to be 65% to over 90%.  So even though MSII is operating at lower volumes and higher costs, MSII has room to sell its cartridges at prices that gives the end users 25%-50% discounts compared to the name brand, gives its dealers higher margins in dollars as well as percentages than they would get by selling the name brand product, and still leave gross margins of over 50% for itself.
Usually it is good policy to own only the lowest cost producer in a field, which MSII isn’t, but that doesn’t apply in this situation where the gross margins are so high, and the OEMs have close to a monopoly on cartridges that work in their printers.  Even if discounters were to grab a fairly big share of market, say 25% for example, the name brands would be foolish to try to win back business through a price war.  From their point of view, why lose margin on that 75% of the market that they would have anyway in order to try to get back some of the remaining 25%, especially when they would have to slash prices 50% to drive discounters from the market?
For background, MSII was founded by the CEO upon graduation from college as an engineer in 1987.  Initially the company provided computer aided design and distributed supplies to the graphics arts industry, getting into its current business with a small acquisition in 2000.  Only in the last several years, as its capital has grown, has MSII been in a position to add to its R&D staff, allowing it to introduce cartridges that work in more printers, and to add to its sales staff to open up more dealer accounts.
MSII’s divides its product line into solid ink products and toner products.  The only printer maker that uses solid ink (aka “ink stick”) technology is Xerox; as a technology it is very competitive with laser color, and XRX has stated it expects to introduce new solid ink printers for years to come.  MSII’s initial products were designed to work in XRX printers, and this category still represents more than half of MSII’s sales.  Ink sticks are made in MSII facility in NJ on its own equipment; MSII last year installed new equipment to improve quality and substantially increase its capacity. 
Toner cartridges, which go into the color laser printers made by everyone other than XRX, represent the overwhelming majority of the potential market, but less than half of MSII’s current sales.  Since MSII already makes cartridges for most of XRX’s solid ink offerings, and it wants its product line to more closely match the overall office color printer universe, most of the new products it expects to introduce will be toner products.  Production for this type is more complicated.  MSII’s Japanese toner suppliers ship their material to contract production companies in Taiwan and China who manufacture the physical cartridges, fill them, box them, and ship them to MSII in NJ.
Solid ink products have a higher margin than toner products, because of a combination of XRX’s high prices and MSII’s direct control over manufacturing.  As a guess, solid ink products probably bring MSII about 55%-65% gross margins and toner products 40%-55%.  So if MSII is successful with new products for the non-XRX market, toner sales will grow much faster than solid ink, and that mix change will lower average gross margins.  But the extra volume from the new products, even at lower gross margins, will add to the operating margin, which is what counts.
In determining what newly introduced printers to develop a cartridge for, MSII looks at a number of factors, including how successful they think the printer will be, how long and how difficult it will be to develop a competitive cartridge without violating anyone’s IP, and whether the printer represents the start of a new family that may go on for many years.   In the past it has taken as long as eighteen months after the OEM introduced a new printer for MSII to introduce its version, an impediment to business since the printer companies often retire a model in two or three years.  MSII’s R&D group has expanded rapidly in the last year, and although its main goal is to increase the percentage of the printer universe for which MSII offers product, it also hopes to reduce the time gap between a printer introduction and the availability of a MSII discount cartridge.
MSII’s products are mostly sold under its “Media Sciences” name, but some larger customers with brand equity sell them under their own private label, and there are some “white box” sales as well.
The laser and ink stick color cartridge market is about $7 billion worldwide, and is expected to grow revenues at a 30% rate for the next five years, according to Lyra Research, which tracks the industry.  The price of color laser printers has dropped considerably in the last two years, and color printing is starting to become standard in office environments, especially as people have become so used to seeing everything in color on the web (even VIC is now using color!)  Increasingly people send me spreadsheets with various numbers or columns color coded for additional information, most of which I would lose if I were to print in monochrome.  In another few years monochrome laser printers may join black and white TVs in the memory of old timers only.
With trailing year’s sales of only $22M, MSII has a minuscule piece of the entire cartridge market.  Part of that is because at this point it offers cartridges that work in only 26% of the office printers in active use (defined as those sold in the last three years.) Even for those printers for which it does offer a product, MSII has a tiny market share, typically about 2.5%.
To some extent that reflects distribution weakness.  Many dealers don’t yet carry MSII products.  Until recently MSII has had a minimal sales force.  Some dealers haven’t wanted to carry MSII’s line because it wasn’t comprehensive enough to bother with.  Also, XRX and some other printer companies offer rebates on all their products, including copiers and the printers themselves, that a dealer sells provided the dealer does not sell competitive cartridges; many dealers would sacrifice more in giving up that rebate than they would gain from the higher margin on MSII products.
This is why MSII is particularly optimistic about the impact on its distribution reach from its newest set of cartridges, which just started shipping two weeks ago, for several Dell printers.  Dell only sells direct to the end user, so this product gives dealers something very attractive to offer to end users who otherwise were closed off to them, at discounts of up to 50% from what Dell charges.  Since Dell doesn’t do business with dealers, there are no rebates or cooperative advertising support that it can threaten to take away.  MSII hopes that dealers who sign up to carry just the Dell compatible products will, if happy with MSII as a supplier, eventually carry its other products.
The main cause, however, of MSII’s tiny market share is, I believe, at the end user level, which I discuss in the next section.
In just about every product or service that exists, buyers can be segmented into those who will pay a higher price to get the name brand, versus those who are willing to buy from a lesser name or no-name in return for a significant discount.  In monochrome cartridges, buyers of discount cartridges take over 30% of the market.
If you don’t agree with me on this, you may as well stop now and forget MSII:  My contention is that the “natural”, or ultimate, size of the discount segment for laser and solid ink color printer cartridges may not be over 30%, but it is certainly much, much more than the 2.5% or so share that MSII presently has.  (Until there are some new competitors, MSII’s share and the discount segment’s share are one and the same.)  Again, 2.5% is MSII’s average share of market for the 26% of the market for which they make alternative cartridges; for those printers for which it doesn’t, by definition it has 0%.
Besides MSII’s distribution weakness listed above, OEMs have had a near monopoly on the replacement cartridge business because until recently there was less reason for users to try or use discount cartridges.  A few years ago office color printers all cost at least a few thousand dollars.  They were typically a perk for upper management, and not used intensively, so the savings from discount cartridges didn’t seem worth the risk.  As the price of the printers have gotten cheaper (color lasers are now available under $300), and are increasingly used actively by more cubicle dwellers, the issue of overall expense becomes much more important, since cartridge consumption costs on an active printer are huge relative to the initial cost.
In other words, it now pays for most color printer users to at least audition MSII’s cartridges, assuming it makes one for their printer.  If they are satisfied by the output, they will find the savings compelling.  Even if their normal dealer source of supply doesn’t carry MSII products yet, they are available fairly widely on the internet.  MSII will be starting a modest advertising program to stimulate end user demand, in addition to its traditional marketing to dealers.  As more users become aware of the savings, I believe previously reluctant dealers will want the line in order to hold onto the discount customers, and with enough volume the higher dealer margins offered by MSII will overcome any loss of exclusivity rebates from the OEMs.
A still untapped market with huge potential is the big box stores (Staples, Office Depot, CompUSA, etc.) who currently offer only the name brand cartridges for color laser and solid ink printers.  For ink jet printers, however, they do offer discount private label cartridges and ink refilling services.  Over the next year or two, as the big boxes sell more of the now inexpensive color laser printers, it will make sense for them to offer discount cartridges for these models.  MSII is the obvious potential supplier, under its own name or as a private label.
This report is already getting long, and I still have a lot to cover, so I thought I would skip ahead to the punch line.  Why do I think this is potentially a $25-$50 stock in a few years?  Simple arithmetic. 
To review, currently MSII offers printers for 26% of the color market, and gets 2.5% market share of those for which it competes.  For round numbers, it is doing business at about a $24M/year rate, its gross margins are around 55% and operating margins around 14%. 
Here is how that arithmetic should change:
1. As a result of MSII’s expanded R&D effort, the number of printers for which it offers cartridges should accelerate, allowing its addressable market to rise to 35%-40% in three years from 26%.
2. MSII’s share of market has enormous room to grow from 2.5%.  As discussed above, ultimately the share going to discounters could easily be 15% or 20% or maybe a good bit more.  So far, there is still no competition doing what it does.  With the kind of margins and top line growth that exists, eventually others will show up, but they haven’t yet.  The printer companies have enormous margins to protect, and they don’t make it easy, increasingly using encoded chips on their cartridges, which MSII has to crack so the printer accepts an MSII cartridge as one of its own.  When competitors finally do appear, my guess is that they will initially target printers that don’t already have MSII competition.  So MSII could plausibly maintain a monopoly of the discount segment for its printer targets for some time after more competitors show up elsewhere in the market.  And, as I said above, the buyer of a $400 printer that will be used heavily is much more likely to try discount cartridges than a lightly used $5000 machine, and the mix is changing rapidly toward the low end.  For the sake of this calculation, I don’t think it is excessively optimistic to assume that MSII’s share of those markets for which it offers cartridges rises to 5% in three years.  
3. The overall market for replacement color cartridges, according to industry studies, is growing at 30%. That should double the overall size of the market in three years. 
So right now MSII has 2.5% of 26% of the market.  In three years it could have 5% of 40% of the market, and the market itself could be almost twice its present size.  Instead of doing $24M/year in sales, MSII would be doing in the neighborhood of $150M/year.  The company will certainly have to execute properly to do that well, but I don’t think the numbers are crazy.  For example, given the speed with which word of bargains spreads on the internet, I wouldn’t be surprised if, for some of its products, MSII can get 10% market share.
And with limited competition, and the name brand companies firmly defending their very high margins, MSII would still have very high gross margins, although lower than today as its mix switches to more toner products, and some competition perhaps makes itself felt on margins.  Operating margins should be higher on that big leap in sales, but even if stable, that would produce EPS of over $1.00 per share.   What multiple could a company with that level of growth get in a few years?  Who knows, but the stock getting into the $25-$50 range wouldn’t be impossible.
Keep in mind that this business in theory ought to be very recession resistant.  When business slows, managers look for ways to save money, and saving 30% on printer cartridges is an easy choice.  Also, companies whose earnings aren’t affected or even gain by a weak economy tend to get premium multiples; it would be a surprise if at some point in the next three years the economy doesn’t weaken enough to demonstrate that point.  And there is no reason why MSII’s growth should stop in three years; it could be a decade before offices are so saturated with color printers that cartridge demand flattens, the discount share of market tops out, and margins get squeezed.
The tremendous tailwinds MSII has, in terms of a fast growing industry and a potentially large but still untapped discount segment, are all well and good, but the company will have to work hard and execute properly to achieve the spectacular growth that seems theoretically possible.
Since my write-up a year ago, the company has focused on building the management team needed to let it get to the $100M+ sales level.  In addition to some new board members and lower level engineers and sales people, MSII has added an experienced CFO, a new head of product development and engineering, and a head of toner development who is Japanese, which helps when working with the Japanese toner suppliers.  In the December quarter it added a sales specialist for the internet dealer channel, and hired a head of European, Middle Eastern, and African sales, who is someone who left a position in the industry where he was in charge of a team responsible for $100M in sales to join MSII.  I believe they are close to bringing on a similar sales heavyweight for the US, one who they hope can develop the big box store channel.  All this new staff adds to fixed costs, and it takes a while for their benefit to manifest itself in the form of new products offered, new dealers carrying the line, and end users buying the products.
With huge margins at stake, the name brand printer companies are not sitting back and making it easy for MSII to introduce a competitive, cheaper cartridge.  Increasingly they are adding encrypted chips to try to prevent cartridges other than their own from working in their printers.  While in theory they could someday come up with ones that MSII can’t crack, so far that hasn’t happened.
The other main defense played by the OEMs is that they patent as much of the cartridges’ shapes and characteristics as they can get away with.  This isn’t as bad for MSII as one might think.  Yes, it makes it that much tougher to come up with a legal alternative, but at least MSII has a large enough R&D staff to tackle the challenge; smaller potential competitors can’t, and don’t show up to undermine either MSII’s margins or market share.
Last June XRX brought suit against MSII, charging patent infringement on one of its solid ink products, which is the discount alternative to what XRX sells for its Phaser 8500 and 8550 printers.  This was the first time any OEM had complained about a MSII product since a dust up with XRX five years earlier, actually initiated by MSII accusing XRX of restraint of trade, and settled several years ago.  In this new suit, XRX is claiming that MSII copied the shape of XRX’s cartridge, which has certain curves in it that allow it to slide down some rails into position.  I’ve seen the XRX product and compared it to the MSII product.  I am no expert.  Perhaps an expert will testify that the two products have essentially the same shape, but they sure looked quite different to me.  The MSII product has no curves, and is quite angular, using some points to hold onto the rail on the way down.  MSII is adamant that its product does not violate XRX’s IP, and is countersuing XRX with a variety of claims.
Regardless of who wins, like most patent lawsuits it will take many years and lots of lawyer bills before a conclusion is reached.  To me, the shape claim seems so far fetched that I suspect that XRX brought the suit just to try to slow down MSII’s growth, tie up its management, frighten its dealers from handling MSII’s line, and have MSII spend money on lawyers rather than engineers who could develop new XRX compatible products.  I think XRX waited too long to do this—if it had sued a year or two earlier than it did, when MSII was smaller and financially weaker, this would have been more serious.  Now it is just an annoyance and an expense, but so far not standing in the way of its growth.  The caliber of staff that has joined the company since the suit was initiated, many of whom were from the industry, suggests confidence on the part of more than just MSII’s management that the XRX suit is bogus.
Nevertheless, if we say that defending a patent suit can cost $1M/year, it is obvious that MSII can’t afford to have to deal with lots of lawsuits.  It has avoided them so far by being diligent in respecting the IP of the OEMs, but if more OEMs pile on and also sue MSII anyway regardless of any merits, just to stop it while they still can, the extra expense would eat into earnings and make it harder to focus on growth.
At some point there may be much heavier competition, with other companies doing what MSII does.  MSII believes this will happen, and operates with a sense of urgency as if it will be happening soon.  Nevertheless, it hasn’t yet.  If it were going to be a big problem soon, I think it would be at least a small problem now, and it isn’t.
Perhaps possible entrants see how tough it is to develop a product that will work right and won’t get one sued, and then develop enough of them to have a big enough product line to attract dealers.  Faced with all that, approaching the market by being a standard remanufacturer, buying up used HP cartridges and refilling them with toner, seems like an easier way to make a living.  XRX’s lawsuit against MSII may even help reduce competition by reminding potential start ups that no matter how hard they strive to avoid violating anyone’s patents, they still better hold aside a million or two to defend against a frivolous patent case.  If a big company wants to get into the business, well, the obvious best way is to buy out MSII.
MSII is in good shape financially, with $2.8M in cash, minimal debt, and total liabilities of $5.4M.  It should be able to grow quite a bit without having to raise any equity.  Its recent sales growth has been decent, up about 20% over the last four quarters, rather than explosive. Despite the buildup of overhead for extra R&D and sales staff, its high margins have kept it showing EPS in the four to six cent range.  Its fiscal second quarter ending December may be a bit tough, with sales probably up near 20% but some big jumps in staff and legal expenses holding down earnings.  The benefits of the rising overhead (other than money spent on lawyers, of course), in terms of strong shipments of the new Dell compatible product line and other new products, and new dealers opened up by the additional sales staff, should start kicking in starting the March quarter, when I expect to see sales growing faster than 25%, and continuing at least at that pace for some time.
An important issue that MSII wants to resolve this year is its manufacturing posture in Asia.  As it stands now, the company deals with outside contractors to make its toner based cartridges.  MSII has no intention of making its own toner, since that is a highly specialized technology, and it has developed good relationships with several Japanese producers.  But it needs to work out a manufacturing solution that will give it much more flexibility in terms of scheduling the size of runs and shipments, and can speed up delivery.  It also needs more packaging flexibility, since the exact same cartridge can be sold in a Media Science box, a white box, or one of a number of private labels, and it is frustrating to have an excess of one when customers need one of the others.  Inventory is too high for the level of business it is doing, and the issues with the present Asian manufacturing are clearly to blame.  In addition, as its European business expands, if it had the ability to ship directly from Asia to Europe without passing through NJ, that would lower shipping costs and have a very favorable impact on the tax rate.  The solution might consist of MSII having its own production facility, or something else, but the company wants this solved this year.  The solution could involve start up costs that hurt the bottom line for a couple quarters before it helps.
One last thing I’ll discuss, because I know it would be asked if I didn’t, is the issue of insider selling.  With one large shareholder selling 4000 shares/day under a 10b(5)-1 plan, and the CEO exercising and selling 5000 shares/week, there are frequent filings.  Although one can’t be a mind reader, I am satisfied that these don’t have any negative implications for the company’s prospects.  The large shareholder is an ultra deep value investor who bought a block directly from the company several years ago at $1.25.  It is part of his strict investment discipline to lighten up when stocks are no longer undervalued and, on a strict margin of safety Graham-Dodd analysis, MSII clearly is not.
Some years ago the CEO was given 500,000 options at $1 that expire in June 2008.  These are the kind of options where the tax is due at normal income rates based upon the value of the day of exercise.  His 10b(5)-1 plan expires in one year, which will cover about half his options, and he may be able to stop the sales there, depending on what happens with the stock.  With nearly all his personal wealth outside of his house in MSII stock, I am not worried about him taking a small amount off the table.  It is always easy as an outsider to say of an exec that they should exercise all their options and borrow whatever it takes to pay for the exercise plus the taxes due.  Since I wouldn’t want him to take excessive risks running the company, I can’t expect him to run his personal life that way either.
In any event, my sense of management and the staff that I have met is that they are all very capable and are aware of the extraordinary opportunity they have in front of them.  The stock is hardly risk free, and the company will have to execute properly on a number of fronts—engineering, marketing, logistics, and unfortunately legal—for the stock to become a four to eight bagger from here.  But at least it has that potential, and I think the tailwinds of the growth in color printing and growth of the discount cartridge from nearly nothing to something significant, should at least prevent the stock from being a disaster even if management doesn’t do everything perfectly.


Accelerating sales and earnings growth, starting with the March 2007 quarter.
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