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Consolidated Graphics Makes for Intriguing Small Cap Value Play

|Includes: Consolidated Graphics, Inc. (CGX)
Consolidated Graphics (NYSE:CGX) looks poised to deliver strong investor returns over the next several years.  Despite its 42% YTD return, the shares trade at a discount to historical multiples and do not fully appreciate the firm's strong free cash flow generation.  I believe future cash generation coupled with modest business or multiple improvement could drive 30%+ annual equity returns with limited downside risk.  Here's why.

1) Revenues and EBITDA should be stable to higher going forward.

CGX has trailing revenues of $1B and trailing EBITDA of $110M.  The company increased September quarter revenues 11% sequentially, and is guiding for flat or sequentially higher revenues in the December quarter as well.  September quarter EBITDA margins were 11%, which is below historical margins of 12.5%-14%.  Revenues and EBITDA stand to improve with any economic recovery.

2) The current valuation is below historical EBITDA multiples and is attractive relative to cash generation.

At the current price of $31.50/share, the stock has a $358M market cap and $580M enterprise value.  The enterprise value is 5.3x trailing EBITDA, 25%-30%below the historical range of 7x-8.5x.  The EBITDA multiple could expand as the economy recovers and margins improve.

CGX generated nearly $140M of free cash flow over the past year (albeit with some stretching of payables) and should generate at least $70M of annual free cash flow going forward.  This equates to a projected free cash flow yield of at least 17%.

3) Strong cash flows could drive 25%+ annual equity returns even without much multiple expansion.

Assume calendar 2011 EBITDA of $110M (no growth over trailing) and a 6x EBITDA multiple (slight multiple expansion but still below historical norms), for a total enterprise value of $660M.  If the company generates ~$140M of free cash flow over the next two years and reduces net debt to $80M, the implied market cap would be $580M, which equates to a $51 share price, 62% higher than the current price and a 2-year CAGR of 27%.

Further, all of the above assumptions could prove low.  Annual EBITDA came in at $135M-$150M before the downturn, historical EBITDA multiples exceeded 7x and free cash flow could eclipse $140M over the next two years. Any positive surprise in one or more of these areas could drive annual returns north of 30%.  For example, $120M-$130M of 2011 EBITDA at a 6x-7x multiple and $140M of net debt reduction would imply 2011 prices of $56-$73, or a CAGR of 34%-52%. 

4) The debt load is manageable.

Current net debt of $222M is a manageable 2x-2.5x annual EBITDA, and annual net interest expense is only $8M-$9M.  CGX used its free cash flow to reduce debt by $146M over the past year.  The existing debt facility matures in October 2011, and CGX should be able to significantly pay down outstanding amounts with its cash flow and refinance any remaining portions.

5) There could be an opportunity to make accretive acquisitions.

Management claims to have an M&A pipeline in excess of $500M in annual revenue as smaller players that lack the scale to compete effectively are driven to consider a sale.  The current dynamic should enable CGX to be choosy in pursuing only the most financially attractive opportunities.

Disclosure: Long CGX