Description

Heidelberger Druckmaschinen (HDD, trading in Germany under the ticker HDD GY) is the largest producer of offset printing equipment for commercial printers (40-45% market share, 2x the #2 competitor). They break their sales down between hardware (Digital Technology) at approximately 60% of sales and services (Lifecycle Solutions). The equipment market is split roughly 50/50 between print (think things like magazines, mailers, etc.) and packaging. Print is in obvious mid to high single digit decline for reasons you can imagine. Packaging is a low single digit grower. While ecommerce is a driver of packaging there are offsets in boxed consumer goods and in channel shifts from retail to the home. Together the market is in some low single digit to mid-single digit decline.

An even bigger headwind to the company is the evolution of digital printing. Digital printing allows for much more flexibility in designing print runs. As the technology has evolved these printers have hit price points that allow them to compete with the older industrial equipment that HDD produces. We estimate that digital printing is now around a 25% share of the market up from 15% 5-7 years ago. We see it at 50% share in the next ten years. With the decline in large print runs for things like magazines, digital has made stronger inroads into print. But it is starting to impact packaging as well, particularly as more niche products have gained popularity at the expense of mass market brands. HDD participates in the digital end of the market primarily through a partnership with Fujifilm. Fujifilm owns the technology in the printhead and from our work takes the lion’s share of the economics.

The company has faced difficult market conditions for years. It was bailed out by its regional German government following the financial crisis. At that time, it cut headcount from > 19,000 employees to approximately 12,500 in FY 2014. It has continued to restructure with headcount now < 12,000. It has acquired companies in the consumables space and a tangential equipment provider (that it is now divesting five years later). It has tried its hand at a new service offering where they effectively finance the customer by holding the equipment. Some years reported results look to have held up, but the trend is unfavorable. The following shows revenue and (often heavily) adjusted EBITDA in €m for FY '15 to '20 (ending March '20).

That is the favorable way to look at the past seven years. Here’s FCF during that time.

This year FY ending March 2021 is predictably a disaster. Sales will be down > 10%. EBITDA will be down marginally, but this includes a €73m gain from a pension transfer we will describe below. Ex this, EBITDA will be < €30m with interest and pension payments run-rating around €50m and capex €50m.

Why does the opportunity exist?

As has been the case with this company for some time, everyone loves a good restructuring story! You have a company that had been doing in the €170-180m in EBITDA and is now looking to cut approximately 15% of the workforce (1,600 workers). They have penciled in €140m in cost savings in the '21/'22 FY and €170 in '22/'23. The local German brokers who cover this are happy to give them some credit for cost savings. Consensus EBITDA for 03/23 is €174m but there is a €200m estimate out there as well. We would point out that this fiscal year has €80m in cost saves. Consensus EBITDA is €89m with €73m coming from the aforementioned pension asset transfer. While the environment is clearly negative these costs savings are not evident in the numbers.

The second reason the opportunity exists is that the company has bought itself time with the transfer of its pension assets. This deal netted the company €324m in cash. They have maintained all the liabilities of the pension plan, which presently sit on the balance sheet for €978m, up from €488m in FY 2017 (the lowest point in recent history). In exchange for this cash infusion the company has agreed to a fixed pension repayment schedule that starts at roughly €30m a year ramping up to €40m in 2034. In addition to the pension transfer they sold a HQ building and will close on the sale of a business (Gallus) they bought in 2015 for roughly €100m. They used all these proceeds to fund the €125m+ FCF hole this year and to pay down €150m in HY debt. At the end of the year, they will have approximately ̴€130m in net debt.

Finally, the company recently revealed that they have been producing electric vehicle charging wall boxes for installation in residences. Sales, they reported, have been going so well they will double the capacity of the line for their production. This news, which has corresponded with the recent retail mania both in the US and other parts of the globe, has sent the stock from €0.80 to €1.30. We later learned that current revenue for these charging boxes is €15m on a total sales base of around €2b.

But even after this move, a bull would say that you have a €400m MC cap with €130m in net debt (mostly due in CY ’23 and ’24) that can earn €200m in EBITDA. What’s not to like at 2.7x EBITDA! (Putting aside the €1b pension deficit, of course, which we include in the EV above.)

What are you playing for?

HDD is a company that remains in structural decline. No amount of restructuring or marginal efforts like EV wall charging boxes can change that. The treadmill of decline and restructuring is what keeps the opportunity as a short seller alive.

We believe the EBITDA stepdown from around €180m in 03/19 to €102m in 03/20 and now close to €25m in 03/21 has a significant structural component to it. Taking €25m as a base and regaining 10% of revenue, or €200m, at a 50% incremental margin brings you to €125m in EBITDA. They are calling for an incremental €90m in incremental savings over two years on top of the €80m this year (a third of which is temporary). However, their mostly unionized personnel cost pool of near €1b inflates approximately 3% a year, or €30m. Over two years that €90m in savings becomes €30m. That would bring you in '22/'23 to €155m in EBITDA. We consider this an optimistic scenario. But even at €155m in EBITDA there is very little FCF. The company faces €50m in capex at a minimum, that’s half of D&A and a level the company itself says is unsustainable. Pension expense will be €35m on average, interest expense €15m on average, and cash restructuring expense will be at least €40m. In the past there have been other drags to FCF and they will have to grow inventories to grow sales. Together in a best-case scenario you are looking at €15m in FCF for a < 4% yield on equity. A 1% decline in revenue is around €10m in FCF.

Our view is that this may get back to €100m in EBITDA or even €135m but much more than that will be difficult. At those levels you will be FCF negative and rebuilding net debt. Broadly speaking, this is a terminal case trading well above pre-pandemic highs. It has been prone to provide opportunity in the past and this seems to be one of those. That is not to say something like this is a smooth ride down. It surely will not be. We will say that presently there are no listed shorts, which is a first for this in a long time. Usually there are some European funds big enough to show up on the short list, so from a technical standpoint the timing may not be all that bad.

Catalyst

• Weaker than expected topline guidance for FY '21/'22
• Clarity that the EV charging is a limited profitability driver
• Growth in net debt as the company funds the restructuring program