Compass Report--The State of M&A

BY HARRIS DEWESE

(Editor's Note: Harris DeWese is a principal at Compass Capital Partners and an author of the annual "Compass Report," the definitive source of information regarding printing industry merger and acquisition activity.)

Most of you are busy managing independent, privately held printing companies. Some of you lead large, public printing companies. A handful of you run a company you redefined as being in the "communications industry," though presses throb a few steps from your door. Others work to prepare an e-commerce printing Website for an IPO—occasionally dabbing saliva from their chins.

For all of you who are very busy and have little time for reading, here is the Executive Summary from "The Compass Report—2000."

Printing industry consolidation activity slowed dramatically in 1999; only 131 deals were completed vs. 184 deals during 1998, a decline of nearly 30 percent. However, a few very large deals pushed total consideration to a record high of $5.3 billion.

Total sales from the deals also increased to $4.9 billion, attributed primarily to Quebecor's purchase of World Color and AGT's acquisition of Wace. These deals accounted for more than $3.0 billion in consideration and about $2.4 billion in sales. When excluded, total consideration declined more than 40 percent.

The mean public company valuation (market capitalization) declined by 25 percent and by a median of 22 percent. With public company valuations much lower on Wall Street, these buyers are unwilling to pay as much for their private company targets. Therefore, valuations have declined approximately 20 percent since 1998. The range of EBITDA multiples for private companies has declined from 4 to 6 times in mid-1998 to 4 to 5 times presently. As always, there are exceptions to these ranges. There are never hard and fast valuation practices; when steely-eyed analysts are calculating, beauty is in the eye of the beholder.

There are far fewer active buyers (consolidators) for private companies. Where 1998 was a sellers' market, 1999 evolved into a buyers' market. Some of the consolidators have integration indigestion. Others have taken to their beds with severe pain. One or two may not survive.

Wall Street, enamored with dotcoms and tech stocks, has turned its back on the printing industry.

The printing industry is not telling a good story. The excuses for some failed quarterly earnings reports sound like the student whose dog ate his paper and the teacher knows the student doesn't have a dog.

On the other hand, most segments of the printing industry are growing faster than the GDP and the Internet is generating new print sales.

The window of opportunity for sellers in the printing industry closed some in 1999. Once wide open in 1997, it began to descend slowly in 1998 and has been stuck partly open since January 2000.

Deals in 2000 will be fewer and harder to complete due to buyers' pre-occupation with existing operations. More mega-deals will occur late in the year. Smaller, private companies will continue to throw their hats into the consolidation ring.

Eventually, the compelling economics of industry consolidation will prevail and people will figure out how to capitalize on the economies of scale; manage professionally what they acquire; and consolidate the industry in a more orderly fashion.

E-commerce printing Websites will shake out and perhaps themselves consolidate; and a smart few will "learn" what can be sold on the Internet profitably and what cannot. Meanwhile, most traditional printing companies will continue to survive and prosper.

The printing industry will soon learn how to tell its story and stake out a more respected position in American business and industry.

Finally, we encourage analysts and observers to stop generalizing about the printing industry and to focus on the microeconomics and behaviors of the various printing segments.

Printing industry consolidation activity slowed drastically in 1999. When an economic or a financial trend changes direction, there is rarely only one impetus. The slowing of consolidation in the printing industry—and most especially in the general commercial segment—is no exception. Just as there were many factors that led to the 1998 feeding frenzy, there are also many causes for its abatement now.

Its beginning occurred with the stock market correction in September 1998. That correction left publicly traded printing stocks down about 25 percent and the devaluation has continued. Since then, publicly traded printing stocks are down by another 20 percent. But this rejection by investors has also happened to many traditional industries.

Some of the public printing companies' performances, however, have caused Wall Street to turn green at the smell of ink. A few others have the brokers' analysts gagging in the Street. These companies have shot themselves in the foot and in the words of one insider, "We shot ourselves in both feet." The underperformance has been manifest in failures to make earnings projections, announcements of slow internal growth, the NASDAQ delisting of one company, defections of headquarters and plant leadership, and operational problems.

The flaw is not in the consolidation model. That is an inevitable economic phenomenon. And the flaw is not in the printing industry, which is robust and becoming more technologically efficient at blinding speed, with no end in sight. The flaw has been in management. Often, the leadership requisite to build something is not the management requisite to maintain it.

Private printing company valuations have declined approximately 20 percent since 1998. Let's say you owned a successful, $12 million, general commercial printing company in 1998, with an adjusted (normalized) EBITDA margin of 15 percent. This means you had adjusted EBITDA of $1.8 million. You decided to sell your company and engaged spirited competition from several consolidators. In the end, you selected the highest bidder, which offered six times adjusted EBITDA, or $10.8 million. Let's say you had $2.8 million in interest-bearing debt, so you and your shareholders received net cash of $8 million at closing.

Maybe you did not sell in 1998, but would like to sell now. Your numbers are the same now as in the 1998 scenario shown. Except today you will be lucky to engage any competition at all. If you do, it will be between perhaps two or three somewhat ambivalent and distracted buyers. And, instead of six times EBITDA, you will get a best offer of only five times, or $9 million. When you subtract the $2.8 million in debt, your equity has shrunk from $8 million to $6.2 million—a decline of 23 percent.

You will protest during the transaction that your buyer in 2000 paid seven times EBITDA for the same type of company back in 1998. Your buyer will tell you that its stock price in 1998 was 15 times EBITDA and, today, it is less than half that amount. The buyer will also respond that its transactions must be accretive rather than dilutive. This means, of course, that your deal must contribute to earnings per share rather than subtract from earnings per share—no matter how small your drop is in the buyer's bucket.

There are fewer active buyers for private companies. "The Compass Report—1999" Deal Log contained 186 transactions completed by 65 different buyers. This year's report contains 131 deals completed by 39 buyers. Many of the 65 in 1998 and many of the 39 in 1999 were strategic buyers who made only one or two acquisitions for market share or vertical or horizontal integration purposes. These buyers differ from consolidators who employ a rollup and earnings growth strategy to build value.

The consolidators who numbered about 15 on January 1, 1999, amounted to no more than five or six at year-end. Some of those consolidators that remain active can be characterized as passively interested or highly selective. Only three buyers can be characterized as aggressive.

Some of the consolidators have developed integration indigestion. One consolidator told us, "We are suffering from a sophomore slump: We have not been able to improve our earnings and we haven't learned how to manage former owners who are now our plant presidents."

Consider the problem of a consolidator. It buys a company and suddenly the former owner/CEO is a millionaire. His wealth is no longer tied up in a printing company and his motivation has changed.

Some will operate in a spirit of pride to continue growth and good company performance. Others will resist the controls imposed by the consolidator and gradually escape to the golf course or fishing hole. Still others will be offended, and hence less motivated, when they are no longer considered able to make decisions they made routinely in the past.

Wall Street has turned its back on the printing industry. If your company is public, the story needs drastic improvement. Section 5 of the report details the decline in public company stocks and their underlying performance ratios.

Unfortunately, our industry remains highly fragmented—segmented into a multitude of specializations ranging from tickets and coupons to billboards—and the profitability and growth of fragmented industries are hard to track. Who can accurately tell us if short run, perfect-bound book printers have an average return on investment (ROI) of 8 percent or 80 percent? Who knows for certain whether earnings growth for long run, gravure label printers is 3 percent or 30 percent?

We can track the profitability and growth of some of our largest public companies through their earnings reports and annual reports. However, these companies are highly diversified and serve a variety of markets with a variety of printed products.

The printing industry is not telling a good story. All this confusion among apples, oranges, pears and bananas renders many attempts to forecast print growth useless. One survey focuses primarily on sheetfed general commercial printers and purports a slowing of growth. Another polls print buyers who purchase products from only a handful of print segments and also predicts slower growth. Still another study—conducted by CAP Ventures—found that companies using the Internet for marketing are experiencing, on average, a 21 percent increase in their print volumes. This, the report concludes, is due to reaching more prospective customers and responding to Website inquiries with printed materials.

So, if we don't know our story, Wall Street can't either. However, it does know when a company is de-listed after its stock drops a precipitous 85 percent in one year and it fails to make its earnings consensus estimate for three straight quarters. It does know when two of the most visible consolidators fail to make consensus estimates for two quarters running.

On the other hand, the news is good. Many segments of the printing industry are growing faster than the GDP and the Internet is generating new print sales. Internet companies have become the darlings of the printing industry rather than a competitive threat. Leaf through any national magazine and count the dotcom ads that were non-existent one year ago. Drive along any expressway and count the dotcom billboards. Order anything on the Internet and examine all the printed material in the box and how much direct mail follows.

The window of opportunity for sellers in the printing industry began to close during 1999. Once wide open in 1997, the window of sales opportunity began to descend slowly in late 1998. Although still partially open, the window shows no sign of reversing its descent and has been stuck since late January 2000.

From 1997 to 1998, the open window admitted mosquitoes, roaches and butterflies. In 2000, the window of opportunity for selling is open only to butterflies. The window will accommodate only high-performance companies with superior managers who wish to stay on duty.

In most instances, these companies must have sales in excess of $10 million and EBITDA margins well north of 10 percent. Preferably, these companies should have a top and bottom line growth plan, and managers who can explain it. The equipment should be reasonably new and there should be no major capital expenditures on the near-term horizon. The sign on the consolidation window reads, "We buy no futures. Turnarounds and workouts not admitted."

The buyers who hang these signs are also quick to tell you, "There are not many of us. If you want to sell and we like your company, don't tinker too much with our purchase agreement. And if we find any hair on the deal during due diligence, we will probably walk." They will quickly add, "We've got a long line of sellers and we're busy trying to fix some of the plants we bought in 1998."

The year 2000 will see even fewer deals. We predict there will be a range of 85 to 100 printing companies acquired during 2000.

There will be more mega-deals, with undervalued big companies selling to bigger companies. About four to six of these transactions will be mega-deals, with large companies acquiring other large companies. Already this year, Mail-Well (NYSE), annualizing around $2.5 billion, has announced a $334 million tender offer for American Business Products (NYSE), with 1999 sales of nearly $500 million.

Rumors are swirling about other possible transactions and it is just a matter of time before the likes of Donnelley, Moore, Standard Register, Reynolds & Reynolds or Deluxe decide to diversify into some segment of commercial printing.

Private companies will continue to throw their hats into the ring. In spite of lower values and fewer, more selective buyers, small companies will continue to hang For Sale signs during 2000. This anomaly will occur as independent owners feel the increasing press-ure of the consolidators' buying power on their margins. Consol-idator savings in purchases of consumables, equipment, benefits and the cost of capital are now ranging from 6 percent to as much as 12 percent. Small companies simply cannot find those kinds of savings.

The compelling economics of printing industry consolidation will prevail. Eventually, smart people will figure out how to capitalize on the economies of scale; manage what they acquire; and consolidate the industry in a more orderly fashion.

In addition, those consolidators that are already on the right track with multiple product platforms aimed at the print needs of national accounts will learn how to market themselves and cross-sell. This, we predict, will begin to happen well before 2005.

E-commerce printing Websites will shake out and consolidate. A smart few e-commerce printers will "learn" what can be sold on the Internet profitably and what cannot. When the e-commerce printer shakeout occurs, some venture capitalists who bet the farm will wonder what they were thinking when they were told traditional print relationship selling was obsolete. Meanwhile, most traditional printing companies will continue to survive and prosper. Just as before, some will survive while others fail.

The printing industry will learn how to tell its story. It will stake out a more respected position in American business and industry. This will begin to happen about the time competition and fragmentation begins to take its toll on the Internet stocks and Wall Street learns again there is no such thing as a fast buck with legs.

Analysts should stop generalizing about the printing industry. Finally, we encourage printing industry analysts to focus on the microeconomics and behaviors of each printing segment, rather than generalizing about an entire industry.

Financial SEC compliance printers are very different from financial printers that serve the Wall Street broker research report market and they, in turn, are different from the financial printers that print promotional material for the mutual funds. Some segments are already consolidated. Others remain highly fragmented. Some segments are more capital-intensive while others are more people-intensive. Some segments are growing in double digits and others are merely on pace with the GDP.

The good news is that if you own a healthy and handsome printing company, there are buyers and your company can be sold this year. The bad news is that you will have to work at it; but, hard work is how you made it healthy and handsome in the first place.