Finding underappreciated businesses in a rising market is difficult, but we have been drawn to ‘value’ investments instead of ‘growth at a reasonable price’.
One example is Valassis Communications, a NYSE-listed business that fulfils our quality, value and dividend criteria.
Valassis appeared in the top quintile of our valuation screen. Its return on invested capital is high, suggesting a quality business, but its price-to-earnings ratio is low, inferring minimal price risk.
The business was founded in the 1970s, printing money-off coupons for consumer products’ firms. Valassis then paid Sunday newspapers to include their coupon inserts. Last year, more than $4.5bn (£3bn) worth of coupons were redeemed in the US. While that business is cash-generative, falling newspaper circulation and other pressures prompted Valassis to make a significant acquisition in 2007.
More than 80 per cent of the group’s operating profits now originate from a business that bundles advertisements from local and regional businesses for delivery by the US Postal Service. They are selling inexpensive advertising that can be targeted down to the sub-zip code level or to about 3,500 households. Excluding the credit card companies, Valassis is the US Postal Service’s largest customer.
Evaluating the business, some analysts have been concerned by technological advances in the coupon area. We are less perturbed. Store scanners cannot read smartphone screens and the manual sorting of coupons is easier than doing so virtually.
Furthermore, this is no longer the driver of Valassis’s profits. Local advertising delivered through the mailbox is unlikely to be displaced by technology. If anything, with local newspapers in decline and technology allowing users to avoid ads, the letter slot seems more valuable than before. Valassis’s business risks are more likely linked to managing its transformation, but as the only national provider of bundled print ads, Valassis has a defendable market position.
It is important a business generates cash profits that can support its dividend. When the recession arrived, Valassis was busy integrating the junk-mail acquisition and coping with rapidly rising newsprint prices. In spite of this, it still generated free cashflow after all of its capital expenditure requirements. In those days, excess cash was used to reduce the debt used to make the acquisition. Starting in this fiscal year, Valassis has committed to a regular quarterly dividend and to spending a minimum of 35 per cent of its free cashflow on share repurchases.
In terms of financial risk, bank financing is a useful, low-cost source of funding, but must be appropriate for growth prospects. We are comfortable with Valassis’s fixed charge cover of 5.8x and that it is using its cashflow, not debt, to finance its dividend and share repurchases.
Since the business risk of Valassis is quite high, we need the price risk to be low: its shares are trading on a prospective price-to-earnings ratio of 8x, it has an enterprise value of 5.5x, a free cashflow yield of 12 per cent, and has a current dividend yield of 4.9 per cent.
Carl Stick is manager of the Rathbone Income fund
