Description
ProQuest Company (“ProQuest”), formerly known as Bell & Howell, is a publishing and information services company. ProQuest has a very attractive mix of businesses with a high degree of visibility. Due to a confluence of factors over the past several months, ProQuest currently trades for only 11x forward earnings. The stock is heavily shorted, with 20% of the float (15 trading days) sold short. There are some very specific catalysts in place that will drive short covering and move the stock back towards its intrinsic value of 20x earnings in the coming months.
ProQuest is the public market reincarnation of an old Bass Brothers LBO, which, until recently, consisted of an eclectic mix of largely unrelated businesses. Roughly three years ago the management team embarked upon a major strategic overhaul, the purpose of which was to simplify the company’s business mission, divest unrelated assets, and transform the company into a provider of highly scalable electronic information. Management divested several cyclical equipment businesses (high speed imaging equipment, mail sorting equipment), used the proceeds to pay down debt, and completed its transformation by renaming the company and completing a secondary stock offering midway through 2002. The secondary offering consisted of both primary and secondary shares, the latter of which included roughly half of the remaining Bass Brothers stake.
ProQuest currently operates in two divisions, Information & Learning and Business Solutions. These are detailed briefly below:
Information & Learning (“I&L”) (60% of revenues, 50% of operating profit) –The I&L division transforms 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 products provide full image content as it appears in the original publication, as opposed to competing products that are typically only available in text-only format. The company’s rights encompass roughly 25,000 periodicals, including the The New York Times, The Wall Street Journal, and The Washington Post. This collection is the third largest in the world behind the Library of Congress and Britain’s national library. ProQuest has the exclusive rights to sell much of this material into the public and university library markets. Electronic solutions currently represent roughly half of the division’s revenues, with traditional solutions (microfilm and print-on-demand) comprising the balance. Electronic solutions grow revenue in the low to mid teens, while traditional solutions grow revenue in the low single digits. The company’s premiere electronic solution is ProQuest online, an Internet-based database that provides access and search functionality to its fully imaged database of historical material. The electronic solutions also include customized electronic course packs sold to university students. Much of the division’s revenue is subscription-based, with subscriptions typically running for one year and renewal rates in excess of 90%.
Business Solutions (40% of revenues, 50% of 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, and renewal rates exceed 90%. This business has performed ahead of expectations recently.
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. The company’s cost base is highly leveragable. In recent quarters as much as 60% of incremental revenue has dropped to the operating income line.
ProQuest’s stock has taken a beating lately as a result of several factors.
· The company’s revenue performance has been below expectations since the secondary offering earlier this year. In addition, it came in several pennies shy on the earnings line in the most recent quarter. Prior to the secondary offering, the stock was very thinly traded and was primarily in the hands of value investors (Tweedy, Browne is and was the largest shareholder) and a small number of special situations funds. The underwriters of the secondary placed stock primarily with growth accounts, so when the lightness in the revenue line materialized the market reaction was brutal. The revenue weakness has been confined to the I&L division, where the company has experienced both competitive pressure for its low-end product and budgetary pressure from library customers that have had their budgets squeezed by state legislators. Original expectations were for overall 2002 revenue growth of 10-12% for the year; instead, the company has come in around 7%. Despite the concerns surrounding state budgetary pressures, all signs point to electronic products continuing to garner an increasing percentage of library budgets and overall dollars spent on electronic solutions continuing to grow.
· Short sellers have targeted the stock due to a mismatch between the company’s reported earnings and its free cash flow. The short sellers have focused primarily on the 2002 numbers, an analysis which is incomplete for the following reasons: 1) ProQuest’s cash flow is highly seasonal with the major cash inflow occurring in the just-completed 4th quarter (since many of the subscriptions are annual, and collection is in 4Q). Shorts have focused over the last few months on the 9-month numbers and have implied that the company’s accounting is suspect. Yesterday, the company prereleased its 4th quarter numbers which included disclosure of an estimated $0.80/shr in FCF/shr for the quarter. This should put a lot of the short arguments to rest. 2) ProQuest had nearly $16mm ($0.56/shr) in unfavorable working capital adjustments during the first nine months of 2002 related to its discontinued (i.e. divested) operations. These adjustments were contractual, specifically identifiable, and truly one-time in nature. 3) In years past, when the company was much more highly levered, it monetized many of its subscription receivables. This is a practice that has now ceased, however, there is still a liability of roughly $75mm on the balance sheet related to these monetized receivables. From an accounting standpoint, as the company books revenue associated with these pre-sold receivables the liability draws down and there is no corresponding cash inflow. This contributes to the mismatch between earnings and cash flow. I estimate that for 2002, this deferred income drawdown accounted for roughly $13mm ($0.46/shr) of the divergence between net income and free cash flow. As this deferred income liability tails off over the next few years net income and cash flow will converge. Since this mismatch is not permanent, I believe that the appropriate way to account for it when valuing the company is to use an adjusted free cash number which adds back the drawdown, and subsequently treat the deferred income liability as debt by backing it out of enterprise value. If one simply uses as-reported free cash for valuation purposes, the implicit assumption is that the mismatch is permanent, which it is not. 4) 2002 was a year of significant capital and development investment for the company. ProQuest completed its digitization of The New York Times and The Wall Street Journal backfiles, and put development dollars into a new electronic order entry system. These added roughly $10mm of investment outflows which will not continue going forward.
· The head of the company’s I&L division, Joe Reynolds, resigned abruptly early this Fall, raising concerns (perpetuated by short sellers) that something was seriously amiss. In reality, his departure was a result of diminished responsibilities pushed down on him as part of a structural reorganization. The I&L division serves two distinct end-markets, libraries and universities, and the sale to each of these end markets is decidedly different. Alan Aldworth, then President and COO, decided to split I&L into two subdivisions in order to more effectively address these disparate markets. Joe Reynolds, rather than accept fewer responsibilities as head of only one of the I&L subdivisions, decided to depart. Subsequently Alan Aldworth consolidated his power base, and was recently promoted to CEO.
In summary, I believe that a combination of identifiable factors has depressed ProQuest’s trading value well below its intrinsic value. 11x is an extremely cheap multiple for businesses with the inherent qualitative qualities and growth characteristics of ProQuest’s – high visibility, subscription-based, significant barriers to entry, and excellent renewal rates. Moreover, although the company’s top-line guidance came down over the course of 2002, it is still growing revenues organically at an attractive rate (7%+) in an environment where many companies are struggling just to keep revenues flat. Last night, the company gave guidance on 2003 and it expects a significant convergence going forward between net income and free cash flow.
Valuation:
ProQuest currently trades for 12x 2002 earnings of $1.63/shr, and 11x 2003E earnings of $1.80/shr. I believe that intrinsic value is around 20x earnings, or $36/shr, which represents potential upside of 80%.
On an organic basis, the company grows its revenues at 6-8%. Factoring in both operating leverage and (modest) financial leverage, it should be able to grow earnings at 12-15%. Free cash flow per share in 2003 will approximate $1.50/shr prior to the working capital adjustment for the deferred income liability (which I value separately, as debt). Net income and free cash flow should converge even further following 2003. My intrinsic value calculation is based on a DCF, further details of which I would be happy to share with anybody who is interested.
Although ProQuest does not have any direct competitors, the 20x intrinsic value multiple that I use is a discount to the market multiple of most other high quality information services companies, as well as many lower-quality companies in the education space.
Risks/issues:
Continued (or accelerating) weakness in state budgets.
Further competitive pressures at low-end of aggregated database market.
Given the stock’s valuation prior to last night’s announcement, we do not believe that many investors were expecting ProQuest to hit its numbers or show strong growth, however, there will likely be continued near-term pressure on the stock as the last ranks of growth investors exit their positions.
Catalyst
Short covering as result of 1) just announced robust seasonal cash in 4Q 2002, and 2) convergence between net income and free cash flow for full year 2003.
Competitive wins at low end of market in I&L.
Rejuvenated spending in library and/or university markets.
Sell-side analysts, most of whom came on board as result of the secondary offering earlier this year, have focused almost exclusively on the top line growth aspects of PQE. As a result, most have thrown in the towel given the recent top-line misses. Further downgrades after this morning are unlikely. We believe that once the company begins to hit its new projections, which we believe are achievable, the analysts will likely start upgrading again.
Company yesterday announced 5% share buyback, which represents about 7.5% of float.