Media Sciences International I MSII W
February 10, 2006 - 12:20pm EST by
2006 2007
Price: 3.00 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 33 P/FCF
Net Debt (in $M): 0 EBIT 0 0

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GFX is definitely NOT a value stock based on current numbers, especially after the jump to new highs yesterday on the release of good December quarter numbers. But I am writing it up anyway, because I think GFX has the making of a superb micro-cap growth stock, capable of five or more years of very high (25+%) sales growth, in a business with high barriers to entry, very high gross margins, and many other characteristics that typically earn stocks premium multiples. Translating into English, this is a double digit stock in two years, IMO.

GFX’s business is not one that, on the surface, leads one to imagine either fast sales growth or any ability to maintain high margins. GFX (written up here before in 2004 at $1.70 by the brilliant Jaxson905) makes replacement cartridges for office color printers, designed to compete on a price basis (I’ll call them “value brand”) with the name brand manufacturers’ cartridges in the aftermarket.

Before you jump to the wrong conclusions, let me make some important distinctions. GFX does not make cartridges for monochrome printers, nor for inexpensive ink jet color printers found in homes. It also does not make ink, so it isn’t in competition with chains like Cartridge World that specialize in refilling empty ink jet cartridges, nor does it buy used cartridges and remanufacture them. Basic ink jet technology lends itself to a variety of knockoff approaches, pressuring the entire pricing structure, so GFX stays away.

Instead, GFX makes only new cartridges that use toner for color laser printers, or crayon-like color sticks, used in many Tektronics/Xerox printers. In other words, GFX only goes after cartridges where there is a large amount of patent protection and proprietary knowledge in the name brand product, and therefore there is, and will be, little or no low competition. GFX uses its engineering and manufacturing skills to work around the designs of the name brands and come up with its own patented proprietary solutions that allow it to price a competitive product at, typically, 25-30% discounts to the name brand product, yet still giving itself high gross margins (57 % last quarter).

Its biggest market at present are owners of certain Tektronics/Xerox color printers, but it also goes after certain printers produced by Brother, Epson, Konica Minolta, Oki, and Ricoh, with others to follow. (GFX hasn’t yet gone after any HP products for a variety of reasons, but might in a few years.)

These printers are typically used in offices and are higher priced than home models, although the prices have been dropping steadily in the last few years. That price drop is a key ingredient in the bullish case. As recently as five years ago, an office quality color printer would sell for many times that of a monochrome of similar speed and performance. That premium keeps shrinking. According to numerous observers (OK, some of them with an ax to grind, like the CEO of Xerox), within a few years the price differential will get so small, or disappear, that demand for non-color printers will virtually disappear, just as one couldn’t buy a black and white TV or computer monitor today even if one wanted to.

This price drop, and ultimate elimination of monochrome, has other implications. Several years ago, a color printer might be available only to the CEO and other top brass.
With decent color laser printers now for sale well under $1000, they are spreading throughout organizations. At lower levels the printer is used more, increasing cartridge consumption. And because the purchase price is lower, the corporation is more willing to take a look at the total cost of ownership, in which, for an inexpensive color printer, the cost of cartridge consumption plays a much larger role than the initial cost.

This works to the benefit of anyone who can figure out how to make a cartridge that works in that printer, but sells for a big discount. Of course, the printer manufacturers, to keep the absurdly high margin replacement cartridge business entirely to themselves, regularly claim that use of any other brand of cartridge would void the warranty. This was a serious impediment to an value brand cartridge when color printers were $10,000 jewel boxes for the CEO, but doesn’t weigh as heavily on $700 printers for the corporate masses. Plus GFX offers its own warranty, that it will fix or replace any printer that is harmed by its cartridges, to make it easier for nervous printer owners to take a chance on its products.

The big trends:

1. The number of color printers will continue to explode over the next five or more years as the price differential between them and monochrome comes close to being eliminated. Eventually, color printers will be totally dominant.
2. As color printers become more widespread, cartridge usage per printer will go up, since they will no longer be a precious bauble that only the CEO can use.
3. Value brand cartridges have barely 1% of the market for corporate type color printers now. Over time there isn't any good reason why value brands collectively can’t get at least a 10% share of market—they have about 25% of the monochrome market. Between this factor and #1 and #2 above, we're talking value brand cartridge market growth probably in the 35%+% range for many years.
4. Printer makers will continue to sell printers for tiny margins, while keeping cartridge margins high, the classic razor/razor blade model. They will continue to make it nearly impossible for value brands to compete. But they aren't capable of making it completely impossible--GFX has demonstrated that it has the engineering smarts to get around the patents and undercut the name brands by 30% in price, while still maintaining 50+% margins for itself. It will always be tough and maybe get even tougher, but that is actually GOOD for GFX, because it discourages anyone else from trying, and encourages the name brand to keep pricing very high.

So far, GFX has little competition, although over time the combination of very fast top line growth and excellent margins will attract new players. A small player would take a long time to get up to speed in both technology and distribution, and would probably start with printers for which GFX doesn't offer anything. A big potential player, if one comes along, would be better off buying GFX.

So we have huge growth of the installed base, even faster growth in total cartridge usage, a rising willingness of customers to try value brands, potentially giving value brands many multiples of its existing market share, and continued high cartridge pricing by the name-brands. These are very powerful tail winds for GFX.

GFX is focusing on two things that will further accelerate its growth. It is aggressively adding to its engineering staff, so that it can design cartridges for more printers of more manufacturers, and get them to market sooner. This, plus more intense marketing efforts, will increase SG&A expenses at a rapid pace, which will keep a lid on earnings in the short run, about which I’ll talk more below.

As it stands now, GFX offers cartridges for about 30 different printers. When a printer company offers a new model printer, GFX evaluates whether to make cartridges for it, based upon a number of factors: how successful the product is likely to be, how hard and expensive it will be to design an alternative that doesn’t violate the name-brand’s IP, and how long that will take, among other things. Fortunately, printer companies rarely come up with radical changes in their basic technology, and when they do, there are strong hints much earlier based on what patents they file. Most models are evolutionary, variations on some technology that GFX has already mastered. But GFX will spend the extra effort on a more revolutionary technology change if it appears to be the base of a family of products that will be introduced over many years.

Most color printers are on the market for about two years, before they are replaced with a new model. Sometimes the new model doesn’t change the cartridge design at all, but usually there is some change in shape, size, chip, or other feature. When the changes are tiny, GFX has in the past designed and had ready to ship a competitive product in as soon as 90 days. When a name-brand introduces a radically new design with broad IP protection, it has sometimes taken GFX as long as 18 months to get a product on the market. Usually it takes about six months to a year. Of course cartridges continue to be consumed by the users for many years after a given model is no longer in production, so speed in hitting the market isn’t strictly essential, but sooner is always better than later. This is why GFX is in the process of doubling its engineering team—to go after more printers, and get them into the market sooner.

Production for the crayon-like color sticks, which accounts for about 2/3 of GFX’s business, takes place on automated equipment at GFX’s facility in Oakland, NJ. Toner cartridges are made using GFX’s design and tooling in China and Taiwan, with toners sourced in Japan.

The products are sold through a wide network of dealers, ranging from small computer dealers to store chains such as Office Depot. Some are sold under the Media Sciences label, and some are private label. GFX still has a long way to go to get the distribution it wants. Many dealers still sell nothing but the name brand product, or make no effort to sell these lower priced alternatives to their customers. GFX has been adding sales staff to get more dealers and help them sell more. Although it has hurt GFX’s recent top line growth in recent quarters, GFX has completed a revamping of its toner cartridge line, using new designs that it can sell at a much lower price while expanding its own and the dealers’ margins, giving the dealers a greater dollar profit on the sale of GFX’s product than the higher priced name brands, which should help.

An additional marketing channel is GFX’s program called "INKlusive". For businesses that want to lease a color printer, GFX will provide them with a printer (there are four models available), send them GFX brand cartridges at regular intervals, and provide technical service and support. Depending on the model, the user pays between $79 and $199 per month for two to three years, and at the end of the term gets to keep the printer. A finance company decides who qualifies, and takes all the risk. When a customer’s application is approved, the finance company pays GFX up front for the value of the printer and the supplies, and GFX buys the printer and delivers it to the customer. In other words, cash in and out for the printer is a wash (although it runs through the income statement and lowers gross margins for that quarter), but GFX gets paid in advance for two or three years worth of supplies that it owes the customer, showing up on the balance sheet as deferred revenues. This is good for cash flow, so GFX expects to add some new popular printers help that program grow. The implied interest rate on the leases is still quite high, but GFX hopes to improve that when the contract with the leasing company gets renewed, as its strong cash flow, decent balance sheet, and the payment stats on the program would justify a lower rate.

In terms of numbers, I won’t make any overly precise forecasts. Revenues are currently running at a $20M pace. I believe the powerful tailwinds from the explosion of the color printer population, the likelihood that the value brand share of the cartridge market will soar far above its current 1% or so level, the rapid expansion of printer brands and models for which GFX will offer a low priced alternative, and the paucity of competitors who want to tackle the technical challenges of these more advanced printers, should cause an acceleration of GFX’s top line growth over the next several years. Although the company is actually on a June fiscal year, sales for calendar year 2006 should exceed $22M, next year get close to $30M, and by 2008 be somewhere in the $40M or above area, all the while maintaining gross margins at 50% or above.

The EPS picture won’t look that exciting for the next year, as the company is rapidly increasing its R&D and sales staffs, and will be hiring a CFO. So for 2006 calendar year we probably won’t see much more than $0.15 fully taxed and diluted. By sometime in 2007 the overhead buildup will start to slow, and some nice operating leverage will kick in, such that calendar 2008 could plausibly have EPS of $0.40 or more.

GFX has the characteristics of the kind of companies that get, and maintain, very high multiples. What drives that is the fact that the growth opportunities are quite open ended, since color cartridge demand could well continue rising strongly for another ten years before slowing, and value brands probably won’t achieve their maximum share of market for many years as well. And I believe GFX can gain premium multiple points for the fact that demand for discount cartridges is likely to rise even faster in a recession. So to pick a target, 30 times $0.40 two years from now would get the stock to $12.

As with any tiny company, much can go wrong. Perhaps printer companies will someday come up with a new technology that GFX can’t break. They can’t all do that at once, but enough companies might that GFX might face more limited opportunities. Even there, there is still a huge untapped market of the 99% or so of existing office color printer users who are still buying only name brand replacements. Those printers will remain in use for many years, and GFX could grow for years even if it couldn’t compete on the newest models.

Another theoretical risk would be if the name brand companies cut their prices, but that would be suicidal unless value brands had a very large market share. There is always a risk of patent infringement suits. Even if they lack any merit, they can be very expensive to defend. And a competitor could steal GFX’s designs, giving it the dubious pleasure of starting an expensive patent infringement suit of its own. GFX isn’t involved in any such suits at the moment, but one could show up tomorrow.

To finish where I started, GFX is not a value on current numbers. But it is a value, when one considers how high the numbers could plausibly be a few years down the line, and the kind of P/E ratio it is likely to have then.

Finally, I’ll mention the website is . GFX went public by a reverse merger with a shell in 1998. The company is followed by no one on Wall St. and has minuscule institutional holdings, other than a few who bought a private placement a couple years ago. I find the CEO, who founded the company in the 1980s straight out of school, very thoughtful and articulate, and recommend talking with him should you want to learn more.


Accelerating sales growth, followed by earnings growth, and multiple growth.
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