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Pitney Bowes (NYSE:PBI) is currently trading at a dividend yield of 13.5%, one of the highest in the S&P 500. As of mid-October, approximately 35% of the stock has been sold short. This is the second of two articles. The first article (here) provides the mail system background that is helpful in assessing the company's prospects.

The short seller thesis is that mail is dead and that the company will die with it; the industry is changing, they say, and PBI is not as competitively viable as it once was. Because the company has high debt levels, the company will be forced to use its free cash flow to pay down debt instead of paying dividends, all while revenue is declining as mail volumes decline. There is little equity value left as measured by their valuation of the company.

The basic picture with PBI, in my opinion, is that it has been a dividend grower consistently for the last 30 years. The ability to pay a dividend going forward depends on its free cash flow. As sales decline, there will be less free cash flow available to pay dividends. Sales are driven by mail volumes, which are declining. Free cash flow is further stressed by company debt levels, which increased as a result of acquisitions made in recent years in a changing industry. The company's credit rating has even been affected by the debt levels and EBITDA, enough to have one agency further downgrade the company's debt this past week. Cash flow is further strained by recent restructuring expenses. The extent of each of these forces acting on the company will determine its viability in the future, particularly sales, because that represents the top line potential in determining free cash flow.

As an introduction to company activities, PBI's sales and comps are broken down below. Everything is ultimately driven from equipment sales and mail volumes. Some sales are outright hardware sales and others are sales-type leases. The lease creates a financing receivable on the balance sheet and interest revenue is recognized as lease payments are made. There may be some lag in some of the categories because they are more sensitive to customer spending, but, over the long term, all revenues are essentially driven from mail volumes.

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Perhaps the best way to look at the company is to break it down into two separate units: leasing and everything else. The reason for this is that the balance sheet looks different for leasing activities, more like a bank. The leasing unit has financial assets that could be matched against the same amount of debt; this makes understanding free cash flow easier. As there is run-off in the receivable assets, PBI can use the cash to pay down debt. The breakdown is as follows:

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Now, I did not allocate any SG&A to the financing unit; however, you can see that the financing unit has a consistent 19.5% operating return on its assets, albeit off a declining base. As mentioned above, there were negative sales comps in recent years which drive this decreased financial asset base.

In terms of profitability, the company has been restructuring the business. I calculate an operating profit percentage before any restructuring, impairment charges, or taxes to be stable per the chart above. I want to see how viable the earnings power is net of any non-recurring impairment or restructuring charges. The financing business has maintained its profitability levels and the non-financing business seems to be mostly stable as well (not declining), albeit lower than before the recession.

There are other expenses to consider, specifically non-recurring asset impairment and restructuring charges. These are incurred and may affect cash flow in later periods. The company has taken these charges over their 3-year transformation period which has ended. The result has been lowered reported profitability.

Let's turn to the balance sheet. Goodwill and intangibles account for a substantial part of assets; I will not focus on these in gauging the company's ongoing viability. As you can see below in the highlighted section, the debt left over after the financing business allocation is matched against the company's tangible long term assets. This trend has been declining as the company has paid down debt. Again, isolating the leasing unit makes this clearer to see. Also notice that current liabilities exceed current assets, the extent of which is increasing; companies with strong negotiating power, such as Wal-Mart, can do this and use current liabilities to help finance longer term assets. The result of this improvement freed up cash to pay off longer term debt and that is exactly what the company has done. The debt remaining that is not attached to the financing business has been declining as a percentage of tangible assets although it is still probably too high for my comfort level if sales continue to decline.

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Free Cash Flow

So the lingering question remains: will future free cash flows be adequate to cover dividends and pay down debt?

That all depends on sales, which drives the cash coming in from current operations.

Consider this chart. It shows a 2-year moving average of direct mail volume comps versus PBI sales comps. There is a lag in some of PBI's businesses, particularly the leasing revenues.

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As you can see, PBI's revenues track pretty closely to direct mail volume, particularly before the crisis years. The post-crisis years become a bit muddled. To put this comp into perspective, all capital equipment sales in every industry have been stagnant during these years. Durable Goods is one of the most stagnant economic sectors in the recovery economy-wide; company leaders have prolonged making investments until economic uncertainty is less cloudy. As you can see from the chart below, mail volumes have deteriorated during the crisis and were driven mainly by direct mail volume declines. Remember, direct mail is an advertising expense; companies that were just trying to survive would have cut back on this cost before many other costs.

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If you break down direct mail volumes even further, you can isolate the source of the decline. Consider below.

Notice that of the 22 billion piece decline in direct mail from 2007 to 2009, about 11 billion of it is attributed to credit card and mortgage solicitations. The era of refinancing your mortgage and credit card debt had come to an abrupt end. Per below, financial services make up about 25% of PBI's customers. I don't know what is worse: being a financial services firm during those years, or being the company trying to sell capital equipment to financial services firms.

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This analysis points to a cyclical trend dominating changes in direct mail volumes instead of a secular trend of the decline in mail itself. Standard Mail volumes, as reported by the USPS have stabilized in recent years as companies have continued to use the mail system for advertising. The graph below further breaks down mail volumes; you can see that advertising related material dominates mail volumes.

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Now consider a study commissioned by the USPS to forecast mail volumes by the Boston Consulting Group here. Below is a graph of their projections. You can see that Standard Mail volumes will hold steady over the course of the forecast and the decline is coming from First Class Mail, most likely from less C2C volume and billers going paperless. A -1.5% is a modest decline for total mail volumes; direct mail, if it declines, will be less than that. Remember, PBI comps track direct mail comps. I hold the BCG report valid because it predicted the stabilization of Standard Mail accurately, which many predicted would decline uninterrupted as a secular decline.

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The result of this analysis is my free cash flow projection below. By breaking out the leasing unit, I assume any runoff from the portfolio will be available to pay down debt. It is not how the company nor some other analysts report free cash flow, however, it helps me to isolate free cash flow that is available from sales profits and not from runoff from a declining receivables portfolio. As a result, my calculation of free cash flow is less than what the company would report. Also of note is capex, which is less than depreciation and creates higher cash flow relative to what net income would indicate. I calculate dividend coverage that looks healthy in years to adequately pay down debt levels. I calculate $1.2 billion required to be paid for the company to be back to pre-recession, pre-acquisition level of debt, in addition to using all runoff cash to pay down debts. Of course, if sales improve, then more lease receivable financial assets will be created and the company will have a better capacity to absorb existing debt levels.

I model a 1.0% comp sales increase into the long term. Total mail volume, per the BCG report, will decline by -1.5% while direct mail will likely not decline by that much or not at all. I calculate +1% sales comp with a 2% inflation rate on -1% direct mail volume comp. Remember, PBI revenue tracks direct mail comps over time per above.

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Based on the first article's analysis, the fundamentals of direct mail are solid, further supporting PBI's top line viability. The ROI on Direct Mail has been stable and has offered a higher return than most other ways to spend ad dollars. If there was ad spend that could be reallocated from direct mail, it would be Internet Search. However, there is a declining ROI on Internet Search dollars. I believe the reason is that consumers only consider the top few results in a search. Therefore, the more money that flows into Internet search, the lesser its ROI for advertisers. Either you pay but don't get to the top of the list (less benefit) or you pay even more and get to the top (more cost). Either way, ROIs will compress as more money enters the space, competing for the top spots. In fact, DMA data points to a decline in recent years in the business category of search already:

ROI of Internet Search

20072008200920102011
ROI, per DMA data21.620.220.220.119.7

Conclusion

It appears that PBI's dividend will be protected. Declines in mail volumes recently, particularly that portion requiring high volume automation equipment, had a large cyclical force behind it rather than a secular force which was also likely present but not overwhelming. The nature of the decline, cyclical vs. secular, has shown itself as a stabilizing Standard Mail category in recent years. Fundamentally, the ROI of direct mail is stable and competitive against other ways to spend ad money. Its biggest competitor is Internet search, which has a declining ROI as more money enters that space. I do not think Direct Mail will go away any time soon. As a result, PBI revenue appears protected, at least for the near future.

The result is a buying opportunity with a large dividend yield and the potential for appreciation in the long term as sales recover and investors realize that there is going concern value in the company. In the meantime, the company appears to have the profitability to generate enough free cash flow to provide its dividend as it has for the past 30 years over enough future years to at least make your money back.

Source: Is Mail Dead? Analysis Of Pitney Bowes (Part 2)