STATE OF THE INDUSTRY - Far from Dead

(Editor's Note: The following was prepared by Compass Capital Partners, the printing industry's most active investment banker. Located in Radnor, PA, and headed by Chairman Harris M. DeWese, it represents only sellers and buyers of printing companies. Since 1996, Compass Capital has completed 47 transactions involving printing revenues exceeding $1.5 billion.)

The U.S. printing industry is a bedrock of our economy. Yet, in this day of electronic communication, some are telling us that print-on-paper communication is about to be replaced by alternative media.

Compass Capital Partners has been following the printing industry for 12 years. We have made our living from representing buyers and sellers of printing companies. Today, we are the most active printing industry investment banker in the United States. Since 1996, we have completed 47 transactions involving aggregate printing revenues exceeding $1.5 billion. What we read about this industry is at odds with what we see. This report is our attempt to set the record straight.

Commercial printing is not dead. It is growing, profitable and poised to become even more so.

Who are the commercial printers? Commercial printing companies produce a wide variety of marketing-related products and information-based documents. Marketing-related product examples are catalogs, brochures, flyers, newsletters, presentation folders, pocket folders and product inserts. Information-related printed products include directories, internal newsletters, training materials, user manuals, financial disclosure materials and procedure manuals.

The commercial printing segment is comprised of approximately 38,000 companies, of which only one is a pure-play public company—Consolidated Graphics—with sales totally derived from the commercial printing market. There are another 16 public companies that obtain at least 5 percent and as much as about 40 percent of their revenues from the commercial printing market.

The private companies range in size by annual revenues from less than $1 million to as much as $300 million. The commercial printing sales of the public companies range from as little as $50 million to around $1 billion or more for Mail-Well and the Quebecor/World Color Press commercial printing division.

The commercial printing segment is one of 17 printing segments defined by the U. S. Department of Commerce. The chart on this page lists the segments, together with our view of the largest competitors in the consolidated segments.

Leader of the Pack
Commercial printing is by far the largest of all printing segments with 1999 shipments of $102.7 billion, 786,224 employees and more than 38,000 firms. Commercial printing is the most fragmented of all the printing segments and, consequently, its demographics, performance and future are the most misunderstood.

• Printing and publishing, of which commercial printing is the largest segment, ranks fifth among all manufacturing employers with 1.558 million employees.
• Printing and publishing has been and continues as fertile ground for entrepreneurship with 1,478 new companies, employing 10,856 persons, founded in 1999.
• Commercial printing is a major purchaser of capital equipment, with $3 billion in capital equipment expenditures.
• Commercial printing will purchase more than $18 billion in paper this year.
• Commercial printing's profit leaders generate an average return on sales of 10.04 percent and an average return on equity of 24.75 percent. Our own analysis of the public printers with commercial printing operations indicates that they have generated sales growth since 1997 of 39.3 percent, are currently averaging EBITDA margins (return on sales) of 13.23 percent and EBITDA growth since 1997 of 30.5 percent.

Our analysis of the private commercial printers that we have represented over the past four years indicates even better results: sales growth since 1997 of 49.6 percent, with current average EBITDA margins of 14.51 percent and EBITDA growth since 1997 of 75.6 percent.

Private commercial printing company managers are developing a more balanced and professional approach to management. This management improvement portends even better performance as managers who formerly had a "printing craft" or operations orientation develop a marketing orientation that is accompanied by a much more advanced financial focus. Ten years ago, the average private commercial printing company CEO could neither define nor understand EBITDA or EVA (Economic Value Added). Now they can.

Commercial printing is price competitive—all fragmented industries tend to be. Its private companies, however, tend to have gross margins in the 25 percent to 30+ percent range and EBITDA margins in the 15+ percent range.

Consolidated Graphics owns 65 commercial printing plants, and regularly reports EBITDA margins of 15 percent and gross margins of 30 percent. Although Consolidated has missed its earnings consensus three times, it has been by less than 15 percent of the Street's expectation, and it continues to report good earnings and a healthy balance sheet. Its stock price is more a manifestation of the pain inflicted by Wall Street nowadays when any company fails to meet earnings expectations than of the condition of the commercial printing industry.

The Printing Industries of America (PIA) reported that, for 1999, the industry's profit leaders averaged pre-tax income of 10.04 percent of sales. That percentage was up from 1996's 9.06 percent, 1997's 9.41 percent and 1998's 9.80 percent. The PIA also reported that operating income as a percentage of gross assets for these profit leaders was 15.28 percent in 1999, up from 1996's 12.96 percent, 1997's 14.53 percent and 1998's 14.55 percent.

Furthermore, commercial printers have been able to increase prices at a greater rate than their costs. For example, between 1988 and 1998, printing industry prices rose at an average rate of 3.7 percent, while costs rose 1.9 percent. The corresponding growth rates for 1998-2008 are projected to be 3.0 percent for prices and 2.4 percent for costs.

Sunrise on the Industry
Commercial printing is growing. Shipments grew 16.59 percent between 1996 and 1999, while employment grew 17.84 percent during the same period. The PIA's annual market survey reports that first quarter 2000 sales growth was 7.3 percent, up from 1999's 6.6 percent. Other sources project commercial printing's growth from 1999 to 2000 to be 5 percent, and 5.2 percent to 5.7 percent.

Contrast this predicted growth with the growth of the Gross Domestic Product (GDP). Both "The Survey of Professional Forecasters" and "The Livingston Survey," released on May 22 and June 16, 2000, respectively, by The Federal Reserve Bank of Philadelphia forecasted average annual real GDP growth for 2000 to be 4.9 percent over 1999.

America's for profit and not-for-profit sectors have not abandoned printing as a means of reaching their customers or constituents. Print buyers we have queried are projecting growing print budgets at 10-15 percent annually. They see no other existing media as a substitute for their printing materials. It appears that rather than "killing" printing, the Internet companies have become commercial printing's newest customers. Internet advertisers are buying printing to drive visitors to their Websites.

The commercial printing segment is also undergoing a revolutionary technology change to digital throughput. This began in the early '80s with desktop publishing and it now embraces all departments in the manufacturing process. It is far from a smokestack industry and is, in fact, one of the most digitally efficient of all industries.

The commercial printing process at the leading commercial printers is a highly digitized process that includes:

• Electronic transfer of text and images from client to printer;
• Electronic manipulation of text and images in preparation for printing;
• Electronic transfer of text and images to film;
• Electronic transfer of film to plate;
• Electronic control of the printing press;
• Electronic control of folding and binding equipment;
• Online billing; and
• Online status control.

Equipment and software suppliers are promising new productivity breakthroughs that will lead to even greater speed, productivity and profitability.

The leading printers recognize the importance of electronics in their business. The larger commercial printers are either developing or buying digital capabilities. We track printing industry acquisitions in "The Compass Report." We note that, in 1998 and 1999, 11 acquisitions announced by printing companies were software companies. Three of Bowne's five announced acquisitions in 1998 were software companies.

So why all the industry pessimism? We believe that only Wall Street analysts and disappointed investors are reporting the demise of the printing industry. These "demise reporters" have said that:

• "Commercial printing is dying. It is a mature business that is being killed by either the Internet or digital printing." One analyst has been quoted as saying, "Commercial printing will be dead in four years."
• "Commercial printing is a no-growth business. It is growing slower than the GDP."
• "Commercial printing is intensely price-competitive and its companies experience poor margins."

Our analysis, set forth earlier, is that none of the statements quoted above are true. Then why are we hearing such negativism about the industry?

We believe that Wall Street's perception that commercial printing has a "black eye" has resulted entirely from the misadventures of a handful of public companies—the so-called consolidators. One company, Master Graphics, is in Chapter 11 bankruptcy. It acquired some 16 commercial printing companies between 1997 and 1999 before its losses led to loan defaults and forced lenders to seek relief. From the outset, the leadership of this company was consumed with building critical mass at any price and then failed to manage what had been acquired.

The two most active consolidators, Consolidated Graphics and Mail-Well, have been punished severely for missing earnings expectations and, consequently, carry price to earning (P/E) ratios well below those carried by the public printers, such as Wallace and Quebecor World, which are perceived by Wall Street as operators, not as consolidators. Whereas at the end of October 2000, Consolidated was trading at a P/E of 4.39 and Mail-Well at 4.24, Quebecor carried a P/E multiple of 27.79 and Wallace a P/E multiple of 27.61.

We believe that the consolidators' troubles have not been caused by fundamental problems in the industry, but by issues connected with integrating acquired businesses.

These are management issues, however, and similar to those in any consolidation play where large public company cultures are attempting to assimilate small, privately held, entrepreneurial cultures. There is almost always a performance lapse among the acquired companies while managers learn that public markets are now measuring them. This change in management philosophy never takes among some independent thinkers who now have fat bank accounts from the sale of their companies. In these cases, defections occur and even more time is required to bring the target company up to the buyer's expectation for performance.

Phase II Entered
If undisciplined "acquisitions for growth's sake" consolidation activity was Phase I, Consolidated Graphics, Mail-Well and Quebecor World have all taken direct action to move their corporate development activity into what we are calling "Phase II-Integration and Profitization." One new entrant, Kelmscott Communications, a San Francisco-based private company backed by J.P. Morgan, First Union and Duff Ackerman, is well into this "Phase II" and has embarked on its acquisition programs armed with well-defined integration plans. Kelmscott's pursuit of growth, guided and financed as it is by steely-eyed investors, speaks volumes about the future performance and the desirability of the commercial printing segment.

In reaction to Wall Street's rejection of their earlier business model, Consolidated and Mail-Well have responded with well-defined programs to improve internal growth. These endeavors are rooted in cross-selling to existing accounts, targeted national account development, aggressive sales management and strategic print job deployment for improved plant utilization. These companies are moving from acquisition-driven rollup cultures to customer-driven marketing cultures.

While we believe they will resume buying companies during the next 12-18 months, we also believe that as the sales initiatives are activated at the plant level, they will yield double-digit internal growth. The new internal growth coupled with renewed external growth should result in sales and earnings growth north of 25 percent. As they move into Phase II and 25 percent growth, their P/E multiples should move more toward 8.8 to 16.1.

As we see P/E multiples and stock prices improve, we will also see a restoration of buying activity—this time with a more selective and disciplined approach.

We believe that "Phase III -The Profit Growth Era," will begin by 2003. Equilibrium between printers and their customers will be achieved and the public companies will enjoy gross margins ranging from 35 percent to 40 percent, and EBITDA margins approaching 20 percent.

During this phase, up to eight consolidators will aggressively, but selectively, pursue strategic targets at multiples that will probably be significantly lower than the prices paid during 1997-1998.