Imation: An Option-Like Payoff With Downside Protection

Mar.30.11 | About: Imation Corporation (IMN)

Current Price: $11.16

Imanation (NYSE:IMN) is a distressed manufacturer of storage media that sells at a sufficiently depressed value to provide investors with an option-like payoff. The core business is low-margin and slowly contracting, which has contributed to the company’s financial woes and a 75% collapse in its stock price since 2007. This price decline, combined with its immense financial stability, creates the option-like effect. It is unlikely to trade below liquidation value but possesses the financial tools to effect a modest turnaround.

Financial Integrity and a Margin of Safety

Imation offers investors acceptable protection on the downside, especially given the company’s current distress. Downside can be examined from two perspectives: financial integrity and a margin of safety. The first - crucial for examining a distressed business - determines whether the company possesses the financial resources to continue as a going concern and the second determines whether investors are buying in at a sufficient discount to fair value to ensure safety and satisfactory returns.

Imation’s ability to continue as going concern is beyond question. Imation currently has no long-term debt or significant off-balance sheet liabilities, only a relatively minor purchasing commitment with flexible terms. The company has a substantial store of cash: $300M against a market cap of $433M. That stockpile has been built up through consistent free cash flow production, even in years of substantially negative earnings (FCF of $143M/$56.5M/$71.1M in 2010/2009/2008 respectively). Consistently positive free cash flow means that IMN does not require infusions of cash from the capital markets to fund expenditures, acquisitions, or simple survival.

Stability is aided by the company's low capital expenditure needs. Even in 2008, before cost-cutting and efficiency measures began in earnest, capital expenditures were only $20M. Current capital expenditures are lower still and even at/above 2008 levels they are much lower than combined depreciation and amortization expenses. Management has announced plans to increase expenditures in 2011 as part of their greater restructuring plans, but even a 100% increase from 2008’s capex would be covered by projected cash flows (see below).

The margin of safety here comes from the substantial discount to book value. Currently the P/B ratio is only .55. This discount is so significant that even if all of the company’s intangible assets (valued at $320.4M) were written off immediately it would still trade at a discount - albeit smaller one - to that impaired book value.

The discount is also significant enough that IMN is trading near a rough estimate of its liquidation value (assuming a relatively orderly liquidation rather than a fire sale because the company is not in immediate distress):

This acts as a soft price floor for IMN, since it is unlikely to continuously trade below its liquidation value. The company could potentially impair its liquidation value through poor performance or unwise acquisitions, but as you can see below IMN would require extraordinarily poor performance to seriously impair its liquidation value. Most of its liquidation value is derived from current assets, so another round of restructuring charges would do little to impair its value and only truly severe losses could even moderately deplete its store of cash. Bad acquisitions are still a potential issue and something to be watched after, but since management’s largest hypothetical target would be in the $50M range that would only be a 12.5% loss even on a completely worthless acquisition.

Cash Flows

Imation currently sells for wildly low Price-to-Cash Flow multiples: P/FCF of 3x and an EV/FCF only slightly over 1x (and that assumes that $50M in cash is necessary for the business). Alas, these valuations are temporary and driven by the substantial increases in working capital efficiency over the past three years. Although management no doubt would like to extend their successes further, it is unrealistic to assume that efficiency gains will continue.

Here is a slightly more modest set of rough projections:

These projections are not meant to be predictive, only illustrative. They provide a sense of what effect different outcomes might have. Maintaining the status quo as in scenario A means another 10% decline in revenue, keeping gross margin flat, raising R&D 30%, and seeing SG&A rise to 14.5%. Scenario B provides an idea of how income/cash flows might look if IMN’s fortunes began to improve in 2011. Here revenues again decline 10%, but the gross margin is 2010 gross margin adjusted for the $14.2M inventory write-off. This scenario also shows the impact of flat SG&A and modest improvements in working capital management. The third scenario shows the impact of a lower gross margin (15%), lower revenues (declined 15%), and additional restructuring charges due to the company's continued poor performance.

Scenario B illustrates that management’s goal of shifting resources towards their higher margin products could return IMN to profitability with only a small improvement in gross margin. Scenario C, while not a full-fledged disaster scenario, illustrates that a true disaster rather than a simple bad year or accelerated decline would be required to impair the company’s liquidation value.

Future Developments and Valuation

Ambiguity about the future is key to the option-like nature of IMN. In the face of large paper losses and future uncertainty investors have deserted the company in droves over the years and driven the price down to the point where it becomes appealing for conservative investors.

There has been insider selling but only from Linda Hart, the non-executive chairman of the board. Her sales could be construed as a lack of faith in IMN, but it seems more likely that the sales are tied to her impending retirement from the board of directors in May since none of the other directors - who are privy to the same information - are currently selling.

Management is relatively clear about what it intends to do (switch IMN’s focus to its higher-margin products like secure storage), but the difficulty in accomplishing that task seems off-putting to some. The company’s market value certainly indicates an enormous amount of pessimism. Currently IMN’s enterprise value is roughly $150M (depending again on one’s definition of “excess” cash), implying that investors believe it has almost no ability to succeed. Assets are valued by the cash flows they can produce and investors consequently attach little value to its assets - only $.50 on the dollar - because they appear to be unable to generate positive returns. If the situation changes P/B will rise accordingly. Even a 50% rise would only leave IMN with a P/B of .8, which is still a relatively pessimistic bottom-quartile valuation. A turnaround of this nature takes time, so this matrix breaks down annualized returns based on valuation and time span:

Time Span P/B +25% P/B +50% P/B +75%
1 Year 25% 50% 75%
2 Years 11.8% 22.47% 32.29%
3 Years 7.72% 14.47% 20.51%
Click to enlarge

In the event of a turnaround, only modest returns are needed to provide an investor with a double-digit rate of return over a multi-year period. If the company remains stagnant, then liquidation value limits the potential downside.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.