Media Sciences International, MSII
November 16, 2007 - 1:35pm EST by
2007 2008
Price: 3.95 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 46 P/FCF
Net Debt (in $M): 0 EBIT 0 0

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I’ve written up MSII twice before, most recently this past January. No, I am not a VIC desperado rehashing to meet the required minimum—I’ve already entered my two ideas this year, thank you.  It is just that MSII stock is at new lows because the company encountered several temporary problems, all of which are in the process of being solved, and made certain choices that knowingly sacrificed numbers in 2007 to benefit numbers in 2008 and beyond.  MSII’s potential is as big as ever--being a $100M+ company with high margins in a few years, regardless of the economy, which would easily put the stock well into double digits.  There is no proof yet that it will achieve that potential, but the evidence is getting stronger and should, I believe, be crystal clear within two quarters. There is too much to discuss for just an update, so I am doing this as a new write-up.
The Company and its Market: MSII makes completely new replacement cartridges that go into a number of name brand color laser and color solid ink printers, mostly used in offices.  MSII is not involved with ink jet printers, the kind most people have at home, because that business has lower margins, with numerous competitors selling ink refills or remanufactured cartridges. There does exist some remanufacturers of color cartridges for office 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 certain printers made by Xerox, Epson, Dell, Brother, Okidata, Konica-Minolta, Samsung and some others.  These companies sell a lower volume than HP, discouraging remanufacturers, and price their cartridges higher, making their replacement cartridge markets lower hanging fruit.
MSII’s divides its product line into solid ink products, which was its initial product line, and toner products.  Only some Xerox printers use solid ink (imagine crayons that get melted at the print head), and they amount to perhaps 5% of the total color cartridge market for office type printers.  Color laser printers, which use toner powder, make up the other 95%.  The focus of the company’s ramped up R&D effort of the last two years has been to design new toner cartridges to attack the bulk of the market, and in the most recent quarter its sales of toner product exceeded that of solid ink for the first time.
Solid ink cartridges are made on automated equipment in MSII’s NJ facility.  The supply chain for toner products is much more complicated.  Toner is developed in Japan and shipped to China, where contractors put the powder in cartridges that they have made to MSII’s specs, box them and ship to NJ.  MSII is putting up its own plant in China that will ultimately do most of the manufacturing, providing many advantages and allowing it to avoid some of the problems that cropped up in its toner cartridge sourcing this year, about which more below.
Market Potential: The various printer companies mostly 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 60% to over 90%.  Even with much lower volumes MSII has room to sell its cartridges at prices that give end users typically 25%-30% discounts compared to the name brand, allow MSII’s dealers to make more dollars per cartridge, and still leave gross margins of close to 50% for itself.  MSII still has its niche mostly to itself.  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.  This is not an easy entry business.
The color cartridge market is huge at about $7B, certainly compared to MSII’s size, and growing rapidly.  The main force driving it is the rapid adoption of color as a standard in the previously monochrome-only office market, as people increasingly need to print pages off the web, where color is ubiquitous.  Color printer prices have plummeted in the last five years, making them affordable for nearly all levels in an organization, not just the elite, although the high cost of color replacement cartridges continue to frustrate office managers trying to keep expenses down.
MSII’s total sales don’t even approach 1% of the market.  Part of that is because the printers for which it makes cartridges only represent about a quarter of the installed base, defined as those bought in the last three years.  But even where MSII competes it rarely has much more than 2% of the market, with the other 98% held by the OEM, who sells at much higher prices. 
This is the biggest reason why I think MSII has huge potential.  There is hardly a product in the entire world where some significant minority of consumers wouldn’t gladly give up the security of using the name brand in return for a significant price discount.  In the much longer established monochrome printer market about 30% favors discount cartridges over the name brand.  Several years ago, when a color printer was much more expensive, users were reluctant to take a chance on a discount cartridge, and the OEM’s have worked hard to scare users away from all cartridges except their own.  Now that the color printers themselves are so much cheaper, and cartridge expense so high for a busy printer, that I believe the discount segment of the market is capable of being, if not 30% of all replacement cartridges, at least 10% or 20%.  Certainly, as the economy slows, companies hoping to rein in operating costs should consider switching to a high quality new build non-OEM cartridge at a significant discount, of which so far MSII is virtually the only producer.
This is a huge unmet need.  MSII, with its minuscule market share representing nearly the entire discount segment of the market, could be five or ten times its current size with the right marketing and better distribution.  As it expands the number of printers for which it makes cartridges, and cartridge consumption grows, its potential expands further.
New Marketing Direction:  With a current run rate of $26M in sales, why is MSII not already doing $100M+ in sales if, as I claim, there is a latent craving in the market for discount cartridges?  The main reason (which admittedly I didn’t fully comprehend until this year) is the historical mismatch between where and how MSII’s products were distributed and where and how most potential customers bought cartridges.  MSII until two years ago had a tiny sales and marketing staff, and sold its products mostly to small dealers who sold to small businesses, and dealers who sold only on the internet.  MSII wasn’t represented by the major office product dealer organizations who serve the big corporate customers, nor was it in the major wholesalers who serve those major dealers, nor was it in any major catalog, nor did it have any outside reps to service those accounts.  To make matters more annoying for potential channel partners, MSII wasn’t using the EDI standard for electronic ordering and billing, and its pricing policies, assembled haphazardly over the years, were inconsistent, sometimes charging a higher price for bigger customers than smaller ones.  A potential corporate end user would not have been able to find MSII’s products available through any of their customary suppliers.
Last winter MSII brought in a new head of sales and marketing in the US and one in Europe, both of which had considerable experience in the office products market with much larger companies.  They insisted that MSII had to change its direction and policies so that its products were distributed where more potential customers could buy them.  In the US particularly this required a considerable investment in a much larger and better sales staff to try to develop a relationship with the major wholesalers, to work with them to open up their customers, the major dealers, then work with the sales staff of the dealers to call upon their customers, corporations with large installed bases of printers that could use MSII cartridges.     
In other words, sales and marketing expense would go way up in 2007, but one shouldn’t expect much in the way of actual additional sales until the entire distribution chain was in place.  And aiming the sales force in a different direction reduced efforts to stimulate sales with the existing dealer group, also hurting this year’s sales.
MSII isn’t yet available at every major dealer or wholesaler, but many Fortune 500 companies can now finally buy its products through their usual suppliers, which wasn’t the case six months ago.  And some of the large dealers, attracted by the ability to help their customers save money (while also increasing their own profit per cartridge), are now starting to introduce MSII’s reps to the purchasing departments of some big potential users, and are having some success getting trial orders.  While not yet showing any explosive growth, sales in the September quarter hit a record and are evidently off to a good start in the December quarter.  As these accounts and relationships mature, and MSII products make their first appearance in some major catalogs that are out in January, the company expects much faster growth in 2008. 
In Europe MSII has been making some similar changes, trying to align the way it does business with the way its potential customers traditionally do their buying.  A week ago MSII opened a distribution facility in Rotterdam that will enable quick delivery to customers, while switching to pricing its products in pounds and euros, and making other changes to conform to standard European practices.  European sales were up 39% in the last quarter, and should grow faster now that these impediments have been eliminated.
Despite being conservative due to some missed forecasts in the past, the company has stated that it expects sales growth of at least 30% for its fiscal year ending June.  With the fiscal first quarter coming in at $6.4M, that suggests a progression of at least $6.8M in December, $7.7M in March, and $8.6M in June, give or take.
But these projections are all trivial.  Bigger companies often spend well above $1M per year on replacement cartridges.  MSII, working with their new dealers, is now starting to get introductions and trials.  Some of these will hit over the next year, and possibly many of them will do so, letting MSII easily blow past those numbers in 2008 and beyond.  The tailwinds of tremendous overall growth in cartridge demand, and the likely desire of perhaps at least ten or twenty percent of the market to cut their cartridge expense by 25+% are very intense, and MSII is now in a position to take advantage of them.
Pain, then Gain: Beside increasing sales expense even though it wouldn’t result in significant additional sales for a year, in both the March and June quarters MSII spent extra money to accommodate potentially big channel partners.  In March it changed its pricing so that every part of the channel gets appropriate margins.  MSII voluntarily gave certain potentially big dealers who had bought inventory earlier at higher prices credits to reflect the new schedule.  In the June quarter MSII bought back from a large wholesaler old, obsolete inventory that had been bought years before, clearing the decks for new business.  These adjustments, inventory buybacks and write-offs hurt earnings in those quarters close to $1M, but MSII feels that it is already seeing some positive results from the improved relationship with these important channel partners.
Other Recent Troubles:  The Chinese manufacturer that MSII had used successfully in the past for some toner based products badly flubbed the production of a new product introduced in mid-year.  The quality was completely unacceptable, which was highly frustrating in several respects; MSII supplied perfectly good toner in Japan, shipped it to China where it was put into bad cartridges, and then MSII paid for expedited shipping to NJ, where the flaws were discovered.  There was direct financial loss and orders turned away because MSII won’t ship until the quality is certain.
Concern about having its fate in the hands of outside suppliers is exactly why MSII started the process a year ago of setting up shop in China.  Initially the plant will collect the output of suppliers, test and box the cartridges there, and ship to either MSII’s facilities in NJ, the new European location in Rotterdam (thereby saving US taxes), or in some cases, directly to major wholesalers or dealers.  That operation should be up and running in a few months.  Even just doing that, the impact should be very positive.  Any quality issues can be dealt with there, and inventories can be cut considerably (Explanation for that upon request.)
By later in 2008 MSII will start manufacturing cartridges there itself and rely on Chinese suppliers only for subassemblies and materials.  This will further improve quality, lower inventory, eliminate the risk of piracy by the suppliers, and let MSII pick up 7 to 12 percentage points of manufacturing gross margin.
In addition to the quality problem from China, there was extra transport expense for certain cartridges from there due to bad forecasting (in both directions) that was a consequence of, until recently, not having enough sales people on the street to check potential demand of new products from dealers.
Another factor hurting numbers this calendar year has been legal expenses, which were a hefty $1.2M this calendar year so far, which actually exceeds all of its red ink.  This primarily relates to a lawsuit brought in June 2006 against MSII by Xerox for patent infringement.  In my report last January I explained why I thought the suit was completely bogus, just an attempt by XRX to intimidate dealers from buying MSII’s competitive cartridges.  This case and MSII’s antitrust countersuit against XRX are unlikely to go to trial until the end of 2008, if not settled first.  The odds of a settlement favorable to MSII are good, in my opinion.  XRX itself must recognize that its case is weak, because after discovery it recently dropped its claim of willful infringement that would have dictated treble damages if proven.  In XRX’s attempt to throw out the countersuit, the judge sided almost completely with MSII, agreeing that if MSII could prove its points then XRX would indeed be guilty of anti-trust violations.  From XRX’s point of view, instead of being a case which it could win one way or the other just by forcing MSII to spend lots of money on lawyers, it now faces the risk of losing the countersuit, losing the patent protection on a number of products, paying significant treble damages to MSII, and changing certain practices that keep competitors out.  Perhaps XRX may wait until the case is on the courthouse steps, but I think it now has too much at stake not to want to settle.
There were several other temporary factors that hurt MSII’s numbers in recent quarters, but this report is getting too long as is.  (I’ll be glad to discuss them should VIC members post any questions.)  After two quarters in the red (June Q loss of 4 cents per share, and September of 2 cents per share,) I expect the company to be back to a slight profit in the December quarter and start showing good profits in March.
Finances: MSII’s finances are OK, with about $1M in cash and less than $0.5M in debt, but it may need some funds for working capital if sales expand as fast as I think likely.  It has an unused $3M line of credit that expires in February that will presumably be replaced and expanded.
The company regularly mentions the possibility of doing an acquisition.  I believe they might consider acquiring a small company as a way of gaining certain technical skills quickly, such as in chip development (many printer makers include chips on their cartridges, allegedly to help them work better in the printer, but actually to make it that much harder for any non-OEM to compete.)  An acquisition would probably require some financing, but it is highly unlikely management would consider equity at this price. 
Summary: MSII is a micro-cap with extraordinary potential to increase its sales many times over the next several years.  Its gross margins are high because its competitors, the OEMs, have even higher margins and no incentive to drop them.  Gross margins will probably diminish somewhat over time as MSII’s product mix becomes much more heavily weighted to toner cartridges from solid ink, and at some point competition in the discount segment of the cartridge market will increase.  But competition in that segment has been staying near the zero level for some time, which is evidence of how hard it is for competitors to do what MSII has been doing.
So its position is strong.  All that has happened bad in calendar 2007 has been weak growth in sales while the sales force focused on relationships that take longer to bear fruit, a rise in expenses to accomplish that, some heavy but temporary legal expenses, and some random glitches of a magnitude that wouldn’t even be noticed if they were to happen a year from now, when sales ought to be so much higher.  From September 2005 to December 2006, before it expanded so substantially its R&D and sales efforts, MSII reported operating profit margins in the 15% range.  Over the next few years sales should rise much faster than expenses, and operating margins could well approach that level again, on vastly higher sales.  Yes, various things could go wrong, as in all micro-cap stocks.  But the present market cap of $46M is absurdly low for a company with this potential.


Accelerating sales and earnings over the next several quarters
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