Description

This is an out-of-favor stock with a possible near term catalyst and a generally protected downside due to its low valuation and low expectations.  Every investor is seemingly aware of its longer term secular decline (that is, newspaper circulation is in decline) and I obviously admit that is a concern.  On the other hand, I would argue that VCI’s stock at this price and with the near term uncertainty regarding the ADVO acquisition, has good investment merits.   

Some price history will show the disappointment felt by many investors; over the past 18 months VCI’s stock is down over 60% from a high of $40 that was reached during the summer of ’05 to a near ten-year low of just under $15 per share. 

I always find it interesting to look back at the past to see how the market’s view changes toward particular situations.  The past is just that, but you could argue that looking back is, many times, just as instructive as guessing about the future.  Back in the summer of 2005, analysts who covered VCI were expecting them to earn something around $2 per share. 

As I look over one report from back then, Credit Suisse had a $44 target on the stock and they were raising earnings estimates to $2.04 for 2005 and expecting them to earn $2.32 for 2006.   Expecting a 20 times multiple on earnings seemed reasonable enough to them at that time.  And, with that they even recognized a fear of price cuts in the future.  But in the end, things looked okay to them.   They even said they liked the “secular trends in the industry”.  On balance, it was a rosy enough view from them – and the only mention of big time concern from other analysts was that at around $40, the stocks was fully and fairly valued.   It traded at about 20 forward earnings and 11 times it’s projected EBITDA.  

Things change and, therefore, the market’s view changes very quickly.  And change it has.  Now most everyone “knows” that Valassis’ business is in a secular decline and its advertising services are being characterized as basically pre-historic in nature.  Everyone knows that all incremental advertising dollars are moving and will continue move to online areas.  And of course, everyone knows that with near certainty that Google will be getting the bulk of that incremental spending.  Finally, most analysts and prospective investors strongly suspect that Valassis’ management is ignorant at best and incompetent at worst by attempting to buy such a terrible business like ADVO.  Clearly, this company is dying a slow death.   Now, everyone agrees that it is fairly valued at not quite 10 times its depressed earnings and just over 5 times EBITDA.  Times have certainly changed and remarkably it all changed in 12 months.

I feel the right question to ask is, “what went wrong and will it stay this wrong over the next 24 months?”  I simply believe that the reasonable bad case estimate for the stock price probably isn’t very south of here. And if that’s the case, I can live the outcome, whether it is very good or just good.

First, though, a quick background on what Valassis does. 

Mass Distributed Products

They were written up on VIC back in 2001 and things have changed over this time but what remains their staple service are their “Free-Standing Inserts” placed inside the fold of newspapers across the country.   You probably all notice the annoying coupon booklet inserts that fall all over the floor when you pick up your Sunday paper.  I don’t personally clip coupons, but I am that normal of a person.  Many, many people do use them, however, and according to industry watchers, these free standing inserts actually do help maintain circulation numbers for the newspaper companies.  That is an important thing to remember.

Mostly, these coupon booklets contain ads placed by multiple national consumer products companies.  Valassis states that it distributes these free-standing insert booklets to about 60 million households via about 500 newspapers.   In addition to this, VCI also inserts what are called “Run of Press” ads that are sold by them and placed directly on the pages of the newspaper.   Together, the “Free-Standing Inserts” and the “Run of Press” businesses make up their Mass Distributed Products area makes up about 50% of the overall revenues. 

Over the past five fiscal years, the core Free-Standing Inserts business has dropped.  For example, back in 2001, VCI sold about $580 million in these inserts and now in 2006, they are projecting about $450 million in revenue.  To help offset that decline, they have grown the Run of Press revenue from $32 million to $112 million.  But Run of Press now looks like it has topped out too.  In other words, 50% of their business is in now officially seen as in decline.  For 2007, investors see price competition, reductions in newspaper circulation and finally the Google phenomenon as affecting the revenue line for Mass Distributed Products.

Beyond the core Mass Distributed business, they also have what is called Neighborhood Targeted Products.   Basically, these are one advertiser inserts into the fold of the newspaper.  In this category is their product samples in a small plastic bag product and door hung samples at the front door.  Overall, the Neighborhood Targeted category has grown from about $200 million in sales in 2001 to over $300 million for 2006.

Other Business Segments

Next is their Household Targeted Products business that essentially is a direct mail business.  This business has grown from $40 million in 2001 to about $60 million 2004.   This is the business that they may be diversifying heavily into with an acquisition of Advo.  In the event the merger happens, Advo will add about $1.4 billion in revenues in this segment.  Feel free to read the transcript of the merger conference call for more details regarding possible synergies – it is good reading in light of VCI’s reversal of opinion two weeks later.   

Another important point to make regarding the direct mail segment is its lower profitability.  Advo, for example, nets about 2% to 4% of sales as profit vs. VCI’s net income margin of about 7% now.   This fact may be turning off historical VCI holders. 

Finally, they have International & Services business in Canada, Mexico and Europe that was non-existent in 2001 and now will be a $115 million business in 2006. 

Declining Profitability

A little history on profitability is in order as well.  Over the past five years, VCI’s margins have been falling from an operating margin in the 25% in 2001 to the current operating margin of around 12%.  After the possible Advo addition, it will fall even further.  This drop in profits can be explained almost fully by a drop in gross margins.  Most of this is pricing (due to the other big player, News Corp’s News America) and other competition from alternative advertising mediums (read, the internet, direct mail competitors such as Advo, etc.)   VCI’s SG&A costs have held about steady at 11% to 12% of sales over the past 5 years.  Their gross margins have dropped from the 35% range to now under 25%.    In other words, perhaps it was once a great business and now is just an average business. 

All of this feeds into the negativity surrounding the stock.  My contention, however, is that the drop from the mid $40’s to the mid $20s range is a reflection of this long-term realization of this trend.  The drop to $15 per share appears to be due to the Advo debacle.   In both the case of the long-term industry trend and the uncertainty surrounding Advo, I think that this stock could easily trade at 13x to 15x earnings.  On depressed earnings of $1.50, it now sells for 10x next year’s estimates.   It isn’t at all inconceivable to get VCI back to $20 to $22 on the slightest of good news.  

The Advo Acquisition

Based on estimates, the Advo acquisition (if forced into at the current terms of $37 in cash) will be about a breakeven deal from an earnings standpoint over the next year.  Clearly, spending $1.2 billion to get little visibly in return is quite ugly.  As a conservative view, before trying to back out of the deal, VCI was targeting about $40 million in annual cost synergies that together with Advo’s current operating income will total close to $100 million in incremental cash flow for the new, post-synergies Advo unit.  This basically offsets the cost of the borrowing for the deal.  Thus, no accretion and the margins on the whole business are lowered.  No wonder the market has punished VCI.  But I think they’ve gone too far.

As a bit of scenario planning, if:

(a) if VCI is successful in re-negotiating the Advo deal to say, $32 from $37 per share, then it would add about $0.20 per share in ongoing earnings power due to the reduced interest costs.  At current valuations for VCI, this would likely add $2 per share, but it wouldn’t be unreasonable to expect a bit more of a bounce on this news or

(b) if VCI is successful in getting out of the deal altogether, then I think it wouldn’t be unreasonable to assume that the market would reward the stock with $5 boost on the news.  Why?  A better balance sheet for one, a near miss in the market’s eyes would relieve the negativity and I believe the market management would consider other ways to increase shareholder value or

(c) if VCI is not successful in renegotiating or getting out of the Advo deal, then I believe that the stock already reflects this case.  At 10x earnings – depressed earnings of about $1.50 – this is about the floor.  Now, if the fundamentals deteriorate more and more, then all bets are off.  At $15, I am willing to make the bet that VCI and Advo (if necessary) have businesses that can endure this industry shift.  They will react and adjust to new realities. 

(d) if VCI is successful in navigating through the new realities of their market place and they are able to show some stability or growth in revenues and earnings, I believe that a market multiple of 13x to 15x is reasonable in the future.  They once earned $2.40 back in 2002.  Can they get back to $1.80 or $2.00 in the next couple of years?  With this achieved and with some multiple expansion, a stock in the $25 range isn’t that far fetched.  Over the next couple of years, that kind of gain will probably be pretty attractive…and if it doesn’t happen, well, it probably won’t go too south of here anyway.

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