X-Rite XRIT
September 25, 2006 - 7:02am EST by
dawkins920
2006 2007
Price: 10.30 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 293 P/FCF
Net Debt (in $M): 0 EBIT 0 0
TEV (in $M): 0 TEV/EBIT

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Description

X-Rite is a company that produces color management equipment and software for a variety of end markets.
 
This summer X-Rite, which was the largest company in the color management space, merged with Amazys which was the second largest company.  Amazys is located in Switzerland and shareholders received three quarters of their compensation in cash and one quarter in stock, which meant there were about 7 million shares of stock added to the float held by people who were mostly cashed out and living on another continent. 
 
To make matters worse, customers have delayed purchases from both Amazys and X-Rite as they waited for the merger to close.  As a result both companies experienced flattish sales in the first half of the year, which was well below expectations.  The next twelve months are unlikely to be all that much prettier from a top-line perspective as the companies consolidate and salespeople are let go.  The company has guided to first half 2007 sales that will be flat with first half of 2005.
 
Against this backdrop, the company’s stock sank from 13 to about 8 and has since recovered to about $10.30.  The company today has about 28 million shares outstanding and about $190 million in net debt (not including founder’s life insurance which I will discuss later)
 
Lost in the short-term financial and technical noise is the soundness of the merger.  Although the merger documents and the company’s presentation estimates that X-Rite and Amazys together are about a quarter of the overall billion dollar color market. The next largest competitor, Datacolor, is 6.4%.  My suspicion is that the new X-Rite’s market share is well in excess of 25% in those color management markets that it competes in.  After the merger, X-Rite will have an R&D budget multiple times larger than its nearest competitor, which should allow it to bring better products to market and potentially widen its moat.  (I would encourage anyone interested to run some searches of X-Rite product on the web and see if any competitors are mentioned besides Gretag-Macbeth – which is Amazys’s product line – and Datacolor)
 
In addition, there are major cost synergies that will come from combining the two companies.  Management estimates that it will be able to reduce headcount by approximately 20 percent and that it will be able to produce most of the Amazys product in X-Rite facilities.  All in, management expects run-rate cost saves of about $25 million dollars by the middle of 2009, which is less than 10 percent of cost of goods sold plus less than 15 percent of other operating costs.  In addition, as a result of the merger, X-Rite will be amortizing about $10 million a year of intangibles, which will depress stated earnings but will result in significant tax savings.
 
Modeling X-Rite requires making a variety of assumptions. Below are my estimates through 2010.  Essentially what is incorporated is the following. 
 
  1. Excluding charges, 2006 will be flat to pro-forma 2005.  The only exceptions are that there will be no gain from sale of founder life insurance policies and that the $3.8 million dollar earn out at Amazys last year will not recur.
  2. Growth will be 4% in 2007 and 6% thereafter.  This amount is less than the approximately 9 percent growth that the combined X-Rite would have experience from 2001 until the end of this year, assuming that this year is flat.
  3. Merger synergies take a little bit longer than the company projects.
  4. Operating income contribution margins work out to be about 22% more or less on incremental sales on top of merger savings.  (I actually modeled each line out separately and so there is variance from this in any given year but the result across the entire period is close to this number).  Between 2001 and 2006, contribution margins at X-Rite appear to me to have been a little in excess of 30 percent.  That number is very erratic from year to year, which makes a contribution margin assumption nothing more than a best guess but with a gross margin in excess of 60 percent, a low 20s contribution margin does not seem unreasonable to me.
  5. The tax shield from amortization is about $10 million a year.  This shield reduced GAAP income by about $7 million a year.
  6. The company uses its excess cash flow to pay down debt.
  7. The gains from recent sale of headquarters more or less offsets the 20 million dollar restructuring charge that is coming this quarter.
 
2005 Pro Forma
2006
2007
2008
2009
2010
Net sales
          245,927
                245,927
  255,764
  271,110
  287,377
   304,619
Cost of sales
100,818
100,818
    99,306
  103,733
  107,203
   113,755
Growth
 
 
4%
6%
6%
6%
Gross profit
145,109
145,109
  156,458
  167,377
  180,173
   190,864
Gross margin
59%
59%
61%
62%
63%
63%
Operating expenses:
 
 
 
 
 
 
Selling and marketing
65,885
62,085
    60,462
    61,111
    62,888
     64,802
Percent of revs
27%
25%
24%
23%
22%
21%
Research, development and engineering
28,569
28,569
    27,220
    29,461
    31,744
     33,069
Percent of revs
12%
12%
11%
11%
11%
11%
General and administrative
39,146
39,146
    37,130
    37,664
    38,291
     39,515
Percent of revs
16%
16%
15%
14%
13%
13%
Insurance policy gain
(1,154)
0
0
0
0
0
Total
132,446
132,446
  124,812
  128,236
  132,923
   137,386
 
 
 
 
 
 
 
Operating income
12,663
                  15,309
    31,647
    39,141
    47,251
     53,478
EBIT Margin
5%
6%
12%
14%
16%
18%
Interest and other income (expense)
(16,486)
(16,486)
(16,486)
(13,551)
(11,318)
(8,506)
 
 
 
  
  
  
  
 
 
 
 
 
 
 
Income (loss) before income taxes
            (3,823)
                   (1,177)
    15,161
    25,590
    35,933
     44,972
 
 
 
 
 
 
 
Income taxes (benefit)
            (2,879)
                     (353)
     4,548
     7,677
    10,780
     13,492
Tax Rate
 
30%
30%
30%
30%
30%
Net income (loss)
               (944)
                     (824)
    10,613
    17,913
    25,153
     31,480
 
 
 
 
 
 
 
Earnings (loss) per share:
 
 
 
 
 
 
GAAP EPS
              (0.03)
                    (0.03)
       0.37
       0.63
       0.89
         1.11
Cash EPS
 
 
       0.73
       0.98
       1.24
         1.46
Intangibles Amortization
 
 
10000
10000
10000
10000
Debt Beginning
 
                190,000
190,000
169,387
141,474
106,321
Debt End
 
190,000
169,387
141,474
106,321
     64,841
Interest Rate
 
 
8%
8%
8%
8%
 
 
 
 
 
 
 
Merger Savings
 
 
11,500
17,500
21,500
25000
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
On these assumptions (that the overall company grows less than it did historically and that the merger synergies take longer to happen than management is guiding), the company will do about $1.40 - $1.50  in cash EPS in 2010.  Conservatively, I think the market would put at least a 16-18 multiple on those earnings by the beginning of 2010, which means that from here XRIT should be better than a double across that time frame.  Historically, X-Rite has traded in excess of that multiple and 16-18 times is not unreasonable for a company with good prospects growing mid to high single digits.
 
The largest risk to the position working is a failure to realize the anticipated synergies in the merger.  X-Rite is not a large company and the task in front of them is not simple.  According to management, they are on track and the recent naming of the former CEO of Amazys as head of X-Rite  (which was supposed to happen within 18 months of completion of the merger) is evidence that they are feeling comfortable with their progress and have their ducks in a row. 
 
Also, in the near term, I would expect a very messy quarter.  The company is not closely followed and some analysts have yet to adjust their back half numbers for the merger, which could provide some noise (and perhaps an interesting entry point).   
 
Finally, it is possible that their customers will try to beat X-Rite down on price and that less of the merger synergies will flow through than I am modeling.  I think it is equivalently likely that because of the new X-Rite’s market position that they will gain some additional power over price.
 
On a ghoulish note, one source of upside to my valuation is a hidden asset on X-Rite’s balance sheet.  The company lists the cash surrender value of its founder life insurance policies as $20 million.  According to the company, the face value of these policies is around $130 million (a little under $5 a share) and all of the founders are at least in their 70s.  My understanding is that the cash would come in tax free.
 
 
 

Catalyst

lifting of stock overhang post-merger and realization of merger synergies
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