For the past few weeks, I've been looking into the company Pitney Bowes (PBI). I think the company is a good value pick for 2013 with a favorable risk/reward ratio. All figures I have referenced in the article have either come from Yahoo Finance or the most recent company 10-K annual report, unless noted otherwise.
Pitney Bowes is best known for its mail finishing and shipping equipment systems that are used by small, medium, and enterprise sized companies throughout the world. The company also offers several hardware and software solutions to enable physical and digital communications. Pitney Bowes is a household name in this industry, having been around since 1920. The company has a market cap of $2.4B and has over 28k employees.
Pitney has a strong competitive moat in the postal meter industry. The company has held close to an amazing 80% market share in the US and more than 60% internationally in recent years. There are high barriers to entry in the industry as well, since machines that print postage are highly regulated. Pitney also maintains over 3000 patents related to its technologies.
Catalysts for 2013
Dividend Cut Fears are Overblown -
Pitney has consistently raised its dividend for more than 20 years. As recently as 2007 the stock was trading near $50/share, and its continued downtrend to current levels just under $12/share have meant that the yield has increased substantially. At time of writing the yield sits at 12.7%. One reason the dividend has continued to increase is that cash flows have been strong despite declining revenues in recent years. In 2011, net income was $617m, and just over 50% of this was used to pay dividends ($317m). Pitney also repurchased about $87m worth of stock and paid down $50m in debt.
One of the reasons it is feared the dividend is not sustainable is because revenues and earnings in the mail industry are definitely declining over the past few years (more about this in the risks below), and overall debt levels for the company remain high (over $3B). In fact Debt to Equity is over 800%, which is very high. However, the total amount of debt is a bit misleading and not necessarily an immediate issue, as long as earnings can sufficiently cover the interest and principal payments and not strain other cash obligations. As the high dividend is now one of the primary attractions to Pitney, a big cut in the dividend in order to make interest payments would be a big negative for the stock price. The interest coverage ratio is currently around 5, which indicates some safety for this. Recall from above that the payout ratio is just over 50% for the dividend, leaving room for share buybacks or other capital investments in addition to interest payments. In the chart below taken from the most recent 10-K annual report, we can see that in the coming 3 years, the company has $1.4B of debt related payments to make, for interest and principal. This table was as of the end of 2011, and the $1B in the less than 1 year column has already been paid in 2012. So the $1.4B covers the period of 2013-2015. Currently, the company has about $400m in cash, and it can be expected that it would generate another $900m per year from operations, based on recent levels. Even accounting for some continuing declines in revenue, there would still be more than $2B coming in. Dividend payments are about $300m per year and capital expenditures routinely are around $150m. This seems to leave ample room to pay off any immediate debts and to maintain or even increase the dividend further. Based on this, I think the dividend provides a very attractive downside cushion when looking at a 1 year investment time horizon in 2013. If the business further deteriorates faster than expected, the company could run into trouble a few years from now, but the immediate future seems quite secured.
Any positive earnings surprise likely to cause a significant share price jump -
As is often the case with very out of favor companies or industries, the shorts pile in taking advantage of the downward trend. Pitney is no exception with a whopping short interest of 34%. As the declining revenues and general unfavorable long-term trends of the physical mail industry are well baked into the stock price already, any small positive surprise will cause a nice bounce in stock price and could trigger a short squeeze. If earnings continue their steady downward decline, this is no surprise to Wall Street and hopefully the stock price does not head down too much lower. Even if it does, the high dividend provides a great cushion to lessen the risk of losing too much.
More share buybacks possible -
In 2011 the company purchased over $80m worth of stock. In 2012 as of Q3, no stock had been repurchased. Probably the principal payments of $500m in debt earlier in 2012 factored in the decision to be more conservative with cash. However, with earnings still quite strong, I wouldn't be surprised for further share buybacks which could help to stabilize and ultimately prop up the stock price a bit. The company has consistently reduced the outstanding shares, from 232m to 199m in the past 10 years (reduction of about 15%).
Investment Risk - The Decline of Physical Mail
It's no secret that due to the internet and other communication technologies, the volume of physical mail has seen steady declines over the past 10 years. Pitney has begun several initiatives over the past few years to try and counteract this decline, including selling software to complement its traditional mailing services. These services, however, still make up a relatively small part of the overall business (software accounts for less than 10% of revenues and only about 4% of earnings). What's particularly troubling for the long-term future of the company is that 75% of earnings come from its very high margin North American Mailing business and this saw a 4% decline from 2010 to 2011, and has seen further declines in 2012. So even if the company finds a way to offset these revenue declines with technology related services, the new services are almost certain to be much lower margin (where Pitney does not have its near monopoly position), and this means further declines in earnings.
Personally, I believe this is a legitimate long-term threat, but clearly the decline is happening gradually over a period of years. More importantly, as we'll see in the valuation section below, these declines are already well baked into the stock price. So if the company can slow the decline a bit and deliver a few positive surprises in the coming quarters, the stock is likely to easily outperform the broader market. A recent in-depth article on SA related to Pitney explains in detail how the decline in mail volumes is showing some signs of leveling out. Although the volume of first class mail continues to decline about 5% per year, the volume of standard mail has actually increased in 2011. Standard mail fell sharply in the early 2000s, but has recently seemed to level off. As this still makes up about 50% of the total volume for mail and remains an important medium for business advertising, this is likely to slow the decline of Pitney's core business.
The Direct Marketing Association actually predicts that the CAGR rate of Direct Mail advertising will actually increase by 2-3% from now to 2016. So although other mediums are growing much faster, by no means is direct mail as a form of marketing a dead medium. With this class of mail maintaining close to a 50% market share, even with further declines in first class mail it is hard to envision that overall mail volumes will drop by more than 5% per annum in the coming years. As shown below in the valuation section, this indicates that Pitney is currently very attractively priced.
Pitney has more or less been priced as if it were already dead. The forward P/E ratio is 6, and EV/EBITDA is 5.6. Other attractive valuation metrics include a very low P/FCF of 3.6. The company also generates high returns on capital at over 80%.
In terms of fair value, using DCF analysis, I estimate the company to be worth about $19/share, which provides a margin of safety of 38% from current prices. Including the high and seemingly safe dividend yield, this makes the stock an attractive buy. You can play with various discount rates and growth rates using the calculator at GuruFocus. For my calculation, I have used the following inputs:
- Growth rate over 10 years: -5%/annum
- EPS: $3.43
- Terminal growth rate: 0%
- Discount Rate: 12%
I think these are conservative assumptions. First, generally I personally use much lower discount rates. However, due to the seemingly declining core business, I would not consider to buy a company like Pitney unless I think the valuation has gotten really cheap. So in this case I've used a high discount rate to show that even with this and a continuing decline in earnings, there is still a margin of safety in the shares. In the past 5 years, the earnings have actually declined about double this rate; however, I think evidence that parts of the mailing industry are leveling out make this a conservative assumption.
At the present price levels, Mr. Market has given us a very attractive risk/reward ratio on Pitney Bowes. The company has a high dividend payout that seems to be relatively secure in the coming few years despite high debt levels and declining earnings. Furthermore, although the core business has uncertain prospects going forward, these fears are clearly already baked into the stock price and appear to value the company at overly pessimistic rates of earnings deterioration. With the recent slowdown in the decline of physical mail volumes, Pitney could easily surprise to the upside in 2013 with stronger than expected earnings and is in my opinion a good buy today.