Recall downgraded to Sell

Recall's share price is up 36% since it was spun out of Brambles in December last year. Rumours have abounded that the global provider of document management and storage solutions is in talks with its main US-based competitor, Iron Mountain, regarding a potential takeover.

This is despite the company explicitly stating it's 'not in discussions with Iron Mountain or any other potential buyer'. Given Iron Mountain didn't make an offer when Brambles was trying to sell Recall privately in 2012, not to mention the company's continuous disclosure obligations, we see no reason to doubt the truth of this statement.

Even if the company were in secret talks, it would be difficult to get a merger past the Australian Competition and Consumer Commission (ACCC) and the Antitrust Division of the US Department of Justice. Recall dominates the Australian market with a 57% share, while Iron Mountain is the second-largest operator with a 26% share.

Still, it wouldn't be a total surprise if the companies tried to join forces given their increasingly disruptive mutual enemy. As we explained in Recall stands firm as cloud gathers from 21 Feb 14 (Hold – $4.45), the market for electronic, or 'cloud' storage, is expected to grow at 40% a year over the next five years which will bite into Recall's core paper storage business (75% of revenue). Management knows its business model is under threat but has been slow to communicate how it will adapt to the shift to digital storage.

Nebulous ideas

Management shone a little more light on its long-term strategy in its recent full-year results presentation, saying: 'Recall is developing unique digital solutions to enable customers to secure, manage and govern all physical documents held with Recall and all their digital content, regardless of where it resides … trials are underway and commercial deployment is scheduled during FY15'.

Unfortunately, that's still very vague and sounds a lot like 'we're going to upload scanned documents to the cloud'. We were hoping for more depth because if the new product is no different from existing cloud storage services, such as those of Amazon and Google, it will be difficult for Recall to remain competitive over the long term.

Nonetheless, we don't expect a sudden exodus of customers, which face high switching costs and compliance hurdles when changing providers. The cost to extinguish a contract or retrieve and destroy documents can amount to a year's worth of storage fees, so the 70% of revenue that's recurring should stick around for some time yet.

Operating leverage

Around 70 – 80% of Recall's operating costs are fixed, such as labour, property leases, IT and legal expenses. This means that revenue from each additional box in storage flows quickly to the profit line. At least in theory.

After removing the effects of currency fluctuations, revenue for the year to 30 June rose 7% to US$836m, although that was partly due to the acquisition of the 51% of Recall Singapore that the company didn't already own. Organic revenue growth was a modest 4% with the underlying number of managed cartons increasing just 2%.

The operating leverage inherent in a business with mostly fixed costs means that when revenue is growing and costs are stable, margins improve and profits grow even more quickly. Under this scenario, Recall's 4% organic revenue growth would be quite respectable.

Unfortunately, the company's costs grew 7% after a sales and marketing push caused labour expenses to rise materially, so margins contracted and underlying earnings before interest and tax (EBIT) was slightly lower than the previous year at US$133m.

We'd feel more comfortable with the aggressive spending on sales and marketing if it were accompanied by a strong digital strategy or a proportional lift in revenue. At this stage, however, it seems just as likely to be a reflection of higher costs to retain customers given increasing competition as it is genuine investment driving 'organic growth momentum' as management claims.   

Valuation

Recall has $484m of net debt and a further $585m of operating and property leases. However, interest expense is comfortably covered by operating earnings so the debt should be manageable given the company's steady and recurring revenues.

Management expects revenue in 2015 to increase in the 'high single digits' and EBIT to grow 'less than revenue growth' implying operating expenses will continue to increase faster than sales in the year ahead.

The share price is largely unchanged since we placed the stock under review on 30 Sep 14 but has risen 27% since Recall stands firm as cloud gathers on 21 Feb 14 (Hold – $4.45). With a price-earnings ratio of 22 and a forward unfranked dividend yield of around 3%, the market is clearly banking on a lot of growth or there being a takeover in the works despite management's insistence on the contrary.

Either way, the current price is only justifiable with a hearty dose of speculation and we recommend you take advantage of the market's enthusiasm. SELL.