1010 Printing: Undervalued

1010 Printing Group (1010) provides printing services to international book publishers as well as print media companies. Its products comprise illustrated leisure & lifestyle books, educational textbooks and children’s books. The company is headquartered and listed in Hong Kong but currently earns the majority of its revenue from Australia and the US (~67% of FY 15 revenue).

The company’s small cap status and a pessimistic industry outlook have resulted in its stock being both under-followed and undervalued. The current valuation, however, ignores the company’s track record of disciplined bolt-on acquisitions, its niche positioning within the print industry and its excellent management team. I believe the share price could be worth more than HKD 1.80 per share within the next 18-24 months, which represents at least 40% upside from an entry price of HKD 1.28 per share.

The company was originally established as a subsidiary of the Cinderella Media Group in 2005. It was listed separately on the Hong Kong Stock Exchange in 2011 and eventually spun-off by the parent company in 2014. For the entire backstory, I recommend you read gvinvesting’s excellent write-up on Value Investors Club.

In recent years, the company has made some shrewd bolt-on acquisitions. The first was the acquisition of Asia Pacific Offset Limited (APOL) in 2012. This was followed by the acquisition of OPUS Group Limited (OPUS) in 2014. Both of these acquisitions were financed conservatively, via a combination of cash and capital issuances (with no economic dilution to existing shareholders).

APOL was a complementary, accretive acquisition that allowed the company to broaden its client base in both Europe and the US. The company was acquired for a total consideration of HKD 160m, whereas it earned HKD 40m net income the year prior to acquisition (a ~4x trailing earnings multiple). As a result of the acquisition, earnings per share increased from 11.03 HK cents in 2012 (adjusted for the rights to fund the acquisition) to 16.66 HK cents in 2013. The business has struggled somewhat in the past year as a result of a pricing war with a major competitor, but management believes the longer term outlook is stable.

The circumstances of the OPUS acquisition were different. At the time of purchase, OPUS was heavily indebted and struggling to make its repayments. In July 2014, 1010 bought the company’s AUD 51m debt (face value) from CBA for AUD 21m. In September 2014, 1010 recapitalised the company by converting this debt into equity. As a result of the recapitalisation, 1010 now owns ~62% of entire issued share capital of OPUS.

Results since the acquisition have been promising, driven by greater cost discipline and improved capital allocation. In 2014, OPUS suffered an AUD 21m loss. By contrast, in 2015, the company earned AUD 12m (aided by an AUD 2.2m income tax benefit) on a revenue base of AUD 115m. Management successfully reduced overhead costs by ~AUD 10m in one year. These savings came primarily from lower interest expenses, reduced insurance premiums, and a leaner corporate structure.

OPUS has started 2016 promisingly and faces two additional tenders at its McPhersons site which could enable the company to re-establish its leadership position in printing novels in Australia. It also has a debt free balance sheet to help weather any difficult periods ahead. I believe OPUS can contribute ~AUD 8-10m in net income to the group per year from 2016 over time.

The printed book industry is in decline. This trend started even before the introduction of e-books, as people started to use the Internet as the go-to source for information (for example, consider the travel and reference categories). The subsequent introduction of e-books has only exacerbated this trend, for both fiction and non-fiction printed books. 

Despite the challenging long term outlook, there are categories that have been relatively resilient (at least in the short term). These include leisure & lifestyle books, educational textbooks and children’s books. Why these categories? In the case of leisure & lifestyle books, printed formats work better for items that typically serve as collector’s items or as decorative pieces (think of coffee table books). Next, educational institutions have been relatively slow to both embrace and integrate technology into the classroom. Finally, overzealous parents will no doubt continue to monitor and limit the “screen time” of their young children. Although a recent Nielsen report showed children are starting to read e-books for the first time at an increasingly younger age, sales of e-books for children are still far behind sales of e-books for adults.

1010’s management understands all of the above very well and, as a result of its careful positioning, has been able to produce admirable operating results in the face of broader industry challenges. 

On a separate note, a shorter term issue highlighted in the company’s 2015 annual report was a protracted price war started by a major competitor. As a result of these unsustainable pricing trends, two book printers with annual revenue of between HKD 100-200m actually exited the industry in 2015. Management believes its strong balance sheet and net cash position will allow it to get through this difficult period. Furthermore, the company remains extremely disciplined about its pricing strategy and is willing to walk away from unsustainable customer accounts even if it negatively impacts revenue in the short term.

1010 is run by Chuk Kin (CK) Lau, who has an excellent track record of creating value for shareholders. Investors in Cinderella Media, for example, saw annualised returns of 20%+ for the 13 year period he served as CEO and Chairman of the company. Potential investors should also take comfort in the fact that he is currently the largest single shareholder in the company, with a ~39% stake worth ~USD 50m at current prices.

In my opinion, the biggest management risk relates to succession as CK Lau is already 63 years old. In the 2015 annual report, the company announced it had appointed a special committee to identify suitable candidates for the CEO role. Given the existing challenges in the print industry, however, it has been difficult to recruit and retain high quality managers. Investors will have to take a “wait and see” approach here, although I expect CK Lau to remain involved with the company for the foreseeable future. 

Valuation Summary

Source: Company Filings

1010’s recent price of HKD 1.30 per share implies a free cash flow yield of ~18% on the company’s 2015 results. Under a “no-growth” scenario for 2016 (limited improvement in the core business as well as minimal contribution from OPUS), the free cash flow yield is closer to ~15%. The company also has a strong balance sheet with net cash of  ~USD 17m and a current dividend yield of 5.4%.

Since its listing, 1010 has continued to grow its revenue and earnings as well as return capital to shareholders despite challenging industry conditions. In my view, the company should trade closer to 8-10x of free cash flow (~10-12% yield). This implies a share price of up to HKD 1.80 per share, with potential further upside. Even with no re-rating, the company should get to the target price off an increased earnings base within the next 18-24 months.

For the sake of completeness, I have outlined some key risks below. My view is that the current valuation mitigates these risks to a large extent, so investing in 1010 is a “heads I win, tails I don’t lose much” type of bet.

  • Key man dependency – the company owes much of its success to CK Lau’s leadership in navigating 1010 through an increasingly challenging business environment. It is unclear if a successor will have his business acumen and “nose” for a good deal.
  • Further deterioration in industry outlook – Warren Buffett’s “when a management with a reputation for brilliance tackles a business with a reputation for bad economics…” quote comes to mind.
  • Currency fluctuations – 1010 reports in Hong Kong dollars, but most of its exposure is in other currencies. This was a problem in 2015 and is likely to continue given macroeconomic events that are beyond the company’s control.