Communisis (CMS): Paper profits

Communisis (LON:CMS) are a business engaged in, ostensibly, a very boring activity. You might argue it's become more interesting in the last few years; they went from being a company mostly involved in the printing of cheques and direct mail to a more 21st Century provider of 'communication services'. They talk about integrating with their customers, providing bespoke solutions and about investing in higher quality printing methods - they made a big deal of acquiring an enormous high-tech printer a while back. Fortunately, both for us and them, the picture they paint of themselves isn't an entirely typical rose-tinted management view of the business; it is slowly being borne out in the figures. Margins are on an upward trend, the contracts they are winning seem to be tilted towards the more value-added end of the spectrum, they're closing older (and more standardised) sites and - perhaps most importantly - their higher margin segment is claiming an increasingly large share of group revenues.

'Slowly' is something of a key word here; by virtue of the sort of stuff they do - handle customer communications and printing services - Communisis runs fairly long contract times, and even longer customer relationships. A significant bulk of the work they do, I reckon, is still the bread and butter stuff. That's not a bad thing; customer relationships are valuable, after all, and doing the bread and butter stuff allows you opportunities for cross-selling. That potential seemed to be exemplified this week, when Communisis announced another contract win with Lloyds, a half year after their first - itself a big deal since it represented the 'largest contract of its kind in the UK'. Management are, as usual, a bit light on the details - I suppose for corporate confidentiality reasons - but we have at least a few hints. They're taking on '14 existing sites' in the UK, for instance, and '310 roles will transfer to Communisis under TUPE arrangements'. TUPE - for those who don't want to Google it as I had to - is the maintenance of existing staff contracts when the operator changes hands. I can only broadly guess with these figures - and I emphasise the broadly - but it does allow us to make some comparisons. We might, for instance, note that Communisis as a whole currently employs about 1,500 people - so 300 more represents about 20%. We might suppose the average staff member at one of these sites would earn ~£20k a year, multiply that by the number of employees (giving £6m) and compare that to the total wage expense for Communisis as a whole - about £51m - and consider that a figure of roughly 10%. These are nothing but guesses; but it should be evident that the contract is clearly quite material. Lloyds isn't the only company signing up for their services, either - all of the UK's top ten building societies use Communisis's services, as well as numerous other blue chip clients.

What I'm trying to say, in a roundabout way, is that momentum here is good. Things are clearly going in the right direction, and while I usually mean that in the sense of the figures in the chart top-right, in Communisis's case I mean it in an operational sense. The figures are lagging these contract wins. The more regular readers of this blog will probably realise that this is critically important for me - I'm not in the business of holding businesses which have a P/E of 27 without a good reason to do so. Growth is an excellent reason. I'm also comfortable with the adjustments the group makes to go from reported profit to underlying profit - I think the underlying profit is a better figure. If I take the operating figure on that front, deduct interest charges and taxation, the historic P/E is closer to 18. That's not cheap, of course; the valuation is still predicated on growth.

Returns on capital are also great at Communisis; growth is, thus, valuable. Management are still bullish on meeting their 10% margin target in the next few years, which again gives us some sort of baseline for looking at the future. Should revenues grow 20% in the next 3 years - to £300m - management meeting their target would pencil in an operating profit figure of £30m. Since the group needs relatively little capital to create that topline growth, debt shouldn't balloon too rapidly - so we might expect finance costs to remain broadly flat. £27.5m of operating profit is clearly a good sum for a group trading on an enterprise value of about £180m, and is even better if the group is still growing then.

There's a lot of 'ifs' and 'shoulds' in my last paragraph - words I dislike intensely. Ifs and shoulds often turn to disappointments when you're forecasting improvements. Why am I still holding on, then?

Well, there're a few reasons. I did trim my position in Communisis last year, so my exposure to it isn't huge - keeping my original purchase post the significant price rises would have signalled a level of conviction not commensurate with that which I actually feel. Management have delivered, though, over the last few years - and delivered in a pretty consistent way. I like their investment plan, and I like their business plan. I also like the contract wins coming out of the business and the increasing contribution from international sources. For the third time this year, I'm also going to do something which - while having worked before - I might come to regret. My strong hunch, given the figures we have, is that the full year results from Communisis will be above where broker expectations currently sit; and broker expectations are pretty bullish at the moment. Operating profit might well disappoint - there are restructuring costs (the group reckons it'll save £4m a year from them when they finish up) - but I think the underlying figures will impress. Two or three years down the line, I suspect broker forecasts are likely to understate it by more.

So I'm holding. I bought it for clear value reasons - I thought the group was misunderstood and cheap. I'm running the winner for reasons a bit more ambiguous. I'm not in love with the company at this price, but things are definitely going right for Communisis at this point in time. I hold in full knowledge that disappointment will mean a downward re-rating. My baseline scenario leaves it with a little upward value. I don't have a bullish scenario; but there does appear to be a possibility for Communisis to continue winning contracts and increasing their provision of services and there's a good amount of value here in that case.