- The company recently shed its legacy printing businesses, mostly Pennysavers, while investing heavily in new digital areas of marketing and big data analytics.
- The new CEO has implemented a five-year plan bent on re-positioning the company with stronger growth. We expect him to start an M&A campaign that will significantly growth the company.
- The firm's Trillium software is a strong, complementary asset stream that is likely to boost operating margins.
After three years straight of quarterly revenue declines, Harte-Hanks (NYSE:HHS) has stopped the bleeding and returned to top line growth for the second quarter in a row. While they were modest growth rates of less than one percent, it does represent a significant change from the deep declines of more than 25% experienced in four straight quarters in 2012 and 2013.
The company has been restructuring its business model away from the obsolete areas like printing and more towards a diversified mix of digital and big data analytics. The new CEO who started a year ago has been making significant changes to position the company for the future while shedding low or negative growth areas of the business. We also expect the firm to initiate an M&A program that will more quickly alter the business model to the high growth areas of digital marketing.
Harte-Hanks is an insight-driven multi-channel marketing organization with a goal of delivering impactful business results for some of the largest brands worldwide. They assist their clients in gaining insight into their customers' behaviors from their data and use it to create multichannel marketing programs to deliver strong returns on investment for their customers.
They operate within two reporting segments: customer interaction and trillium software. The customer interaction segment is broken into ad agency, marketing databases, direct mail, and call centers. They send 400 million email messages, mail 6 billion pieces of mail, host 73 databases with business intelligence tools, make tele-prospecting calls in 26 languages, handle more than 15 million inbound calls, and distribute 8 billion advertising inserts.
There are five emerging trends that the company is attempting to capitalize on:
- The company has been hit by sentiment against marketing firms that engage in traditional channel marketing. We think this is still a core offering that needs to be used and is still growing.
- Restructuring headwinds have depressed the business near-term, especially within margins.
- M&A strategy could create some long-term growth potential
- Trillium software potential sticky revenue stream
Traditional Media Is Not Going Away Anytime Soon
The company currently derives approximately two-thirds of their sales from the traditional media sources. These activities mostly include direct mailing and contact centers. They have shed some of the lower quality direct mailing assets, namely their Florida and California Shoppers line- a circular operation called The Pennysaver, which they sold for $22.5 million.
We think investors have soured on the company due to their large exposure to the traditional media channels. While some aspects of that channel are weak and dying, overall, the business is still growing at a mature rate (2-3%). By 2016, the company estimates that the traditional market will be $142 billion opportunity, up $9 billion from 2012. The digital segment is growing much faster and represents a $54 billion opportunity by 2015, up from $35 billion in 2012.
(Source: Harte-Hanks Investor Presentation)
We think the marketing firms that can offer a complete and total marketing solution across all channels will be the ultimate winners in the space. Management sees firms that are focusing solely on mobile and web growing at fast clips. But these firms are catering to a small segment of the overall market. We think the firms that have the total solution across not only the web and mobile, but also across radio, print, broadcast and cable TV, and other traditional sources, will be able to garner the largest, Fortune 500 brands as customers.
While traditional media is a slow growth piece of the business, it allows cross-selling opportunities and a total solution capability that is necessary to compete for the large clients. As the company notes, just 50 clients represent more than half of their sales with 72% of their clients staying with them for over ten years.
Restructuring Has Clouded Results
As the company has structured the business to capitalize on the digital movement more directly, while shedding the traditional media that is not complementary to their core offerings, they should be able to expand their operating margins. In the first quarter call, they talked about realigning their cost base, which they thought was out of line with their top line performance. Clearly, as revenues had fallen, they did not keep pace with appropriate cost cutting.
In the second quarter, they noted they made some progress but a great deal of work still needs to be done. This is not going to be a quick process whereby in one-quarter, they shed a significant amount of overhead, either through redundancy elimination or headcount reductions. Margins were hit by the impact of fixed labor costs as the business saw declining revenues. It will take several quarters as they balance short-term performance needs versus long-term strategic goals.
However, the largest change was the new CEO, Robert Philpott, who started in the middle of last year. He began right out of the gate overhauling the company's strategy and increasing investments in digital marketing. He presented a 5-year plan to the board of directors late last year to return the company to revenue growth and profitability. On the most recent conference call, he reiterated that they expect "corrective action on costs" to continue for the foreseeable future.
We think the best piece of the turnaround story is Mr. Philpott and his background as the CEO of Synogate, a global market research firm. Under his tenure there, he expanded the firm into other adjacent businesses including data analytics and business intelligence. At the helm of Synogate, he was able to not only expand sales by a double digit CAGR but also expand operating margin by 35%.
Trillium Software Asset
Trillium is the company's proprietary software that helps global customers more effectively analyze and report on their product. The technology is essentially a high end marketing business intelligence tool that allows customers the ability to manipulate data in such a way that they can make more informed decisions. In the most recent quarter, Trillium software revenues increased 4.3% in the first half to $27 million with operating income of $2.75 million.
Margins from the software segment should continue to push higher from the current 10.1% as they build a base of customers. Meanwhile, they derive significant revenues from the annual maintenance and license fees. These tend to be very sticky and very predictable. The main industry that is relying on the technology has been the insurance and financial market products industries. Given the growth of their sales teams into industry verticals, we expect the software to push into adjacent industries.
As they mature the product and get their sales teams behind it, we think the operating segment will become a hidden gem in the company. This is an asset that has the potential to carry 50%+ margins with 10%+ earnings growth per year. Over time, it will constitute a much larger percentage of the total business than the 10% it comprises today.
On a trailing twelve month basis, the company is trading at a 7.7x EV/EBITDA level. These are levels that are typical for a company that is losing money and there is only a moderate probability of a return to profitability. Harte-Hanks is still generating earnings and has positive free cash flow of $45 million and $59.5 million in cash flow from operations. Also, with $1.23 in cash per share, they have ample liquidity to undertake mergers and acquisitions or accelerate their share buyback program.
Here is where we conservatively see the company's EBITDA levels in 2016. The sell side is fairly thin but their estimates for sales and EBITDA in 2016 are $566 million and $70.5 million, respectively. We think the market and the two analysts that cover the name are underplaying the potential transformation story, the growth in their digital business overtaking the traditional, and the incremental opportunity over the next two years within their proprietary software division. Still, we will use those figures. Below is our assessment of the company with a target of end-of-year 2015.
(Source: Author's Calculation)
Clearly, the market is placing a significant amount of doubt into the sell-sides numbers. We think this is due to sentiment regarding print media, concentration risk and potential risks surrounding mergers and acquisitions distracting them from the core business. Also, there is hype surrounding some corporations moving towards more "hip" and leading technology marketing firms.
We think the downside is actually fairly limited from here with further deterioration unlikely. The heavy investing in digital likely will stave off the hip firms from stealing future business while the strength of their relationships with their top clients with 72% of them having stayed with the company for ten years or more provides stability.
Harte Hanks is in transition but is still generating earnings and free cash flow, a rare occurrence. The management change has boosted morale at the firm and his experience likely helps the firm transition to a more complete and flexible firm. We would not be surprised to see the company begin to undertake several acquisitions over the next few months in order to bolster their digital offering. Meanwhile, we think the Trillium business is being completely ignored by the market and represents an asset that could potentially generate one-third to one-half of the firm's EBITDA in the next two to three years. We conservatively estimate that the upside, barring any large execution stumbles, is 45% or more.