Description

What’s old is now what’s new again. We originally posted ProQuest Company (“ProQuest”) in Jan of 2003 at roughly $20/shr. After trading into the mid $30s over the subsequent 2-year period, largely in-line with our original thesis, the stock has once again traded back down into the low $20s over the last four months. At these levels, we once again believe that ProQuest offers a compelling opportunity with a host of potential value-realization catalysts on the horizon. We believe that ProQuest currently trades for under 12x earnings; this for a business with a high degree of recurring revenue, huge renewal rates, and a vastly improved top line growth profile from what it was just 18 mos ago.

We refer readers back to our original writeup for an overview of the company’s history as a Bass Brothers LBO, and its subsequent transformation from an unwieldy conglomerate to a more focused information services business. To briefly reiterate, the company operates in two divisions, Information & Learning and Business Solutions.

Information & Learning (“I&L”) (65% of revenue and operating profit) – Historically, the I&L division transformed information from periodicals, newspapers, dissertations, and out-of-print books into electronic format (both online and CD-ROM), microfilm, and print-on-demand products. The company’s publishing rights encompass roughly 25,000 periodicals/newspapers, two million dissertations, 150,000 out-of-print books, and 550 special research collections. ProQuest has the exclusive rights to sell much of this material into the public and university library markets, and its customers include over 8000 libraries worldwide. There have been two major developments in this division over the last 18 months. First, the company acquired Voyager Expanded Learning (“Voyager”) in early 2005, a provider of curriculum-based intervention solutions for K-12 students. Curriculum intervention is a high growth area, spurred on in large part by the minimum national standards imposed as a result of the Bush Administration’s No Child Left Behind initiative. Voyager added roughly $100mm in annual revenue to the division (on a base of $250mm), and has recently been growing its top line at annual rates in excess of 20%. The second major development was the recent divestiture of both microfilm and print-on-demand course pack product operations. The microfilm operation, in particular, was nicely cash generative but was a dying business. The course pack business had proven underwhelming, was not growing, and was capital intensive. These divestitures should increase the non-Voyager related I&L organic growth rate by over 300bp.

Business Solutions (40% of revenue and operating profit) – The Business Solutions division provides electronic parts catalogs to automobile repair shops, dealerships, and parts stores. This is a business with very high barriers to entry. Contracts are typically 5-years in length.

Virtually all of ProQuest’s businesses are attractive. Most are characterized by a subscription model with its associated up-front cash collection, deferred revenue balances, and good predictability. The company’s market shares in its respective businesses typically exceed 70%, renewal rates exceed 90%, and an estimated 80% of revenue is recurring.

PQE stock has been a pig lately. There a number of reasons for this, some of which are related to management miscommunication and incompetence, and some of which are not. The first leg down in Oct 2005 (from the mid $30s to the high $20s) was a result of materially reduced earnings guidance for 2005. The earnings reduction resulted from 1) dilution from the aforementioned divestitures in I&L, 2) higher-than-expected dilution from some tuck-in acquisition activity in Business Solutions, and 3) shortfalls at Voyager. The first item is a non-issue. In our opinion the divestitures were value-enhancing from a NPV standpoint, and materially improved the division’s overall growth profile. The second issue, as well, was not material. Business Solutions’ management has historically done a good job building value thru tuck-in activity, and the near-term dilution will abate shortly. Senior management could, however, have communicated the news regarding the dilution in a much more timely and effective manner. The real issue from the market’s perspective was the third item – shortfalls at Voyager. Management had several explanations for Voyager’s shortfall, most of which relate to the hurricane activity in the SE United States late in 2005. Voyager does significant business with both the New Orleans school district and numerous school districts in Texas. The New Orleans school district is, for all intents, now wiped out. That piece of Voyager’s business is gone. The issue in Texas is different. As hurricane refugees streamed into numerous Texas school districts, intervention programs took a back seat to higher priority issues, namely, integrating the huge influx of new students. It appears that Fall semester intervention activity got pushed instead into early 2006. We have confidence that this is the case, as the level of intervention funding in Texas is specifically designated by the state legislature and is allocated for that specific use. Voyager’s products, outside of the troubled LA and TX locales, continue to demonstrate rapid growth and garner huge renewal rates. Of course, any time a management team stumbles on a major acquisition within a year of its close the market rightly puts them in the penalty box, and PQE/Voyager is no exception. We believe that as Voyager’s numbers in 2006 prove that the year-end 2005 shortfalls were primarily related to timing, market confidence in this acquisition will return.

PQE’s more recent leg down, from the high $20s to the low $20s, resulted from an announcement earlier this week that the company had identified accounting irregularities and would be restating its historical financials. The irreguarities appear to be isolated to the I&L division, and are not related to the newly acquired Voyager. For PQE, in particular, this is a real kick in the pants. PQE has a long history battling short sellers (see our original writeup), in part over allegations over accounting issues. In-line with the thesis in our original writeup, management had managed in large part to dispel these concerns over the last couple of years as net income and free cash flow began to converge. In retrospect, the short sellers were clearly not completely off-base. The question is: how significant a restatement will be required, and what is the true earning power of the company? It is our contention that the market has assumed the worst at this point, and we believe that reality will prove to be far more benign.

With respect to the restatement, the issues all relate to recognition of either deferred income or deferred expenses. In other words, these are timing issues that do not affect cash flow. Current information on the extent of the restatement is scarce, but our back of the envelope assessment yields a potential EPS restatement of roughly $0.20/shr downwards. The basic math we are using assumes a $10mm unfavorable adjustment to each of the prepaid royalty (asset), deferred income (liability), and accrued royalty (liability) accounts. In aggregate, this would represent a $30mm reduction in EBIT, which we assume took place over a 3-year period. We feel that this time period is conservative, as management has indicated that financials as far back as 1999 may be restated. On an annual basis, then, we have a $10mm reduction which equates to roughly $0.20/shr. As a check on the potential conservatism of this estimate, we would point out that the prepaid royalty account stood at $17.8mm at year-end 2004, so our $10mm reduction would imply a 55% reduction in the account – a huge number considering that there are (as yet) no allegations of fraud related to the irregularities, and these account balances have always previously passed muster with auditors. For a second check, we look to 2004’s FCF and compare it to net income. In 2004, PQE generated $1.45/shr in FCF, compared to reported EPS of $1.85/shr. 2004 still included some heavy 1-time capex related to digitization of existing non-digital product, so if on a rough cut we assume that half of the $0.40/shr FCF/EPS shortfall related to “accounting irregularities” (and the other half to non-recurring capex overspend) we once again end up at $0.20/shr of lost EPS power. Granted, all of these calculations are extremely rough at this point, but information is very limited. As an aside, we believe that the recent restatement announcement was driven at least in part by the newly appointed CFO, Richard Surratt. Surratt was appointed in late 2005, and represented a much needed upgrade from the company’s previous financial management.

So where does this leave us with respect to the company’s earnings power? We assume the following:

Original midpoint of 2005 EPS guidance = $2.30/shr
Lost Voyager revenue = $0.10/shr
Microfilm/course pack divestiture dilution = $0.20/shr
Business Solutions acqn dilution = $0.10/shr
Accounting restatement = $0.20/shr

Note that we are assuming only $0.10/shr in normalized EPS reduction for Voyager’s recent woes. While management took down 2005 guidance by $0.28/shr on a reported basis to account for Voyager woes, as previously mentioned we believe that a material piece of this is timing-related and will be recaptured in early 2006. As such, we are carving out only $0.10 (rough estimate) as a reduction to PQE’s permanent EPS power.

So:
$2.30 - 0.10 - 0.20 - 0.10 - 0.20 = $1.70/shr in adjusted 2005 earnings power

Assuming 15% EPS growth 2006 over 2005, we get to $1.95/shr in 2006 EPS

While some might assume that 15% is an aggressive core EPS growth target for 2006, keep in mind that the $0.10/shr in Business Solutions dilution for 2005 that we included should be an easy recapture for 2006 as multiple 1-time expenses related to new contract start-up will not recur in 2006. Excluding this dilution, our assumed 2006 EPS growth is in the high single digits.

With respect to value, given the high inherent operating leverage in the business, modest financial leverage, and the materially improved top line organic growth profile, we think that the stock is fairly valued at in excess of $40/shr. Our assessment is based upon a DCF analysis, details of which we can provide if necessary.

With the most recent restatement announcement, ProQuest management has once again shot itself in the foot. The senior management team has a long history of miscommunication and earnings misses. Even prior to the restatement announcement, PQE traded at just a fraction of what we believe is its intrinsic value, and at a material discount to virtually every one of its public comps. Long-time shareholder SPO partners has board representation. We feel that it is likely that both they, as well as other major holders, are growing increasingly impatient with the perpetual missteps. While we personally feel that the company has generally moved in the right direction over the term of current management’s tenure, the road to get there has been far more circuitous than necessary. Roughly 15% of the float traded out over the last two days following the restatement announcement. This is an extremely heavy volume for what is typically a thinly traded stock. We would not be surprised to see filings on PQE from any number of public market activists over the coming weeks and months, as this situation is ripe for agitation.

Senior management reshuffling, thru either direct board action or shareholder agitation, could prove a catalyst for positive change, as could a spin of Business Solutions. Business Solutions generates enormous amounts of free cash, has a very steady growth profile, and if spun, would be an ideal LBO candidate (we prefer a spin + subsequent takeout scenario to the direct sale scenario to minimize tax leakage). We estimate that value for the division would be roughly $600mm as an independent entity in the public markets. Clearly, there are a virtually unlimited number of potential options with respect to debt apportionment between the two entities in the event of a spin, but assuming 2/3 of the debt goes with Business Solutions, (and slightly north of $10/shr in spinco value) this would leave you with a pure-play education/info svcs I&L division growing its top line in the high single digits and trading at a low double digit multiple of earnings. Such an entity would, we believe, be an attractive takeover candidate to any number of strategic acquirors.

Catalyst

Better-than-expected results of accounting investigation and subsequent restatement
Renewed growth at Voyager – proof that portion of 2005 shortfall was solely driven by TX timing
Value realization event for Business Solutions (sale, spin) or more aggressive strategic alternatives assessment for entire company
Appearance of aggressive activist shareholders
New senior management