PMP has finally morphed into the business we always hoped it would be. In PMP: back from the brink in 2015, we argued that PMP was generating substantial free cash flows and that it could buy competitors to improve awful industry conditions.
Since then, PMP has indeed bought its largest competitor but, even better, another competitor, IVE Group, collected two peers itself.
An industry of five ferocious foes, each with an incentive to push as much volume through their assets as possible, has thus shrunk to two, both likely to shut excess supply. A new duopoly is born.
Improved industry structure
Still a tough business
Margin expansion possible
The high fixed costs and high barriers to exit that characterise the industry have encouraged overcapacity and decimated profitability. Better returns, however, will take time. PMP has released a flurry of releases confirming it is decommissioning old presses, closing facilities and cutting staff. Amid all that activity, it also announced a profit downgrade.
Earnings before interest, tax, depreciation and amortisation (EBITDA) for the full year are now expected to be $31m–34m, rather than the $36m–41m expected earlier. There are several reasons for this.
Customers have reacted to a changed industry structure and are delaying signing new contracts. More importantly, weak retail conditions are being reflected in catalogue length. While volumes are expected to be stable, catalogues are thinning out as retailers cut costs. This remains a tough industry.
PMP will carry about $75m of debt by year's end as it utilises cash to complete restructuring and fund asset closures. It has pledged to hold no long-term debt once this batch is repaid. How long might that take?
After all the restructuring and one-off charges, sustainable EBITDA should come to $90m-$100m annually if we assume constant margins. We’ve penciled in about $10m a year for maintenance capital expenditure and, for the next four or five years, the business will be shielded from any tax.
For several years it should be able to generate $70m–80m in free cash flow and, with $60m of franking credits, generous dividends are ultimately possible. We expect most of that cash to be directed to debt repayment so the business should be debt free in two years and pay dividends thereafter.
Free cash flow of $70m–80m would result in the entire market capitalisation being repaid in four or five years. In other words, the business currently generates a free cash flow yield of around 20%.
This is arguably the cheapest business on our Buy list but it also boasts fragile economics. The entire investment case would unravel if PMP or IVE embarked on a price war or capacity expansion.
We note this because our industry gossips say IVE Group has taken an option on a large new printing press and, while it hasn’t yet purchased the asset, it might.
This isn’t the way smart duopolies operate and, while we expect rational behavior, irrationality can’t be ruled out.
Fragility and sensitivity
Good management is most recognisable in tough industry conditions and in fragile businesses – exactly when it is least appreciated. PMP is never mentioned in lists of companies with excellent management but there's a decent case that it should be.
The merger integration has been flawless (take note, Vocus) and early savings are encouraging. The real upside is in restoring crushed industry margins.
Years of overcapacity has decimated heat press print prices and eliminated about $500 a tonne from unit margins. Industry profits are sensitive to prices: a $100 per tonne change to prices will equate to about $40m in profits so, if the new duopoly can recapture margins lost over the past five years, industry profits could increase by about $200m.
PMP, with a market share of around 60%, would capture the bulk of that upside, worth about $120m. IVE would also benefit handsomely. Profits could potentially explode if margin lost over the past half decade is restored.
That would be nice, but we aren't counting on it. A more likely scenario is that IVE and PMP work to cut capacity and are forced to share margin benefits with customers. That wouldn’t recapture what the industry has lost but it would still provide ample upside to our investment case.
Without any margin increase, with the latest profit downgrade and even after including maximum debt levels, PMP trades with an enterprise value to EBITDA multiple of just 4–5 and a free cash flow yield of around 20%. Expanding margins would be the icing on an already tasty cake. This is a brittle business, to be sure, but there is enough value and optionality to maintain a BUY.
Disclosure: The author owns shares in PMP.