Fair Value Estimate: 910p ¦ Economic Moat: Wide
Thesis
(Last updated 29/03/10)
De La Rue is a leading player in an industry where an established reputation is the key to success. The company's business centres on the design, printing, and handling of currency and other security documents. Many small and some large countries outsource all or some portion of these processes. The products De La Rue deals with are highly sensitive, and having an established record is crucial, as the risk governments would face in dealing with unproven vendors is too great. As a result, the industry is characterised by a few large global firms and other smaller firms that concentrate on specific countries. We think top players like De La Rue benefit from a wide economic moat.
De La Rue believes it is the largest global player. It has relationships with 150 countries; its customer base is diversified, with 28% and 13% of its revenue generated in Europe and the Americas, respectively, and the balance coming from around the globe. It might be surprising that any country might choose to outsource such a vital component of its economy, but many small countries lack the resources to design and print a secure currency on a cost-effective basis. Companies like De La Rue step in to fill this gap, taking advantage of the scale efficiencies of handling so many currencies to offer countries these services at a substantial discount to the cost they would incur in doing it themselves, but still at a price that locks in economic rents for De La Rue. The company's reputation and scale protects its high profitability, factors that are reinforcing over time. As a result, we think the barriers to entry for this business are very high.
The global trend toward credit or debit card usage doesn't deeply affect De La Rue's business, although it might be a bit of drag. Until the world is completely cashless--an event we believe is unlikely to happen anytime soon--De La Rue will remain in business. In fact, the company estimates that the volume of banknotes worldwide has increased at a 3% rate over the past 10 years. But that growth can be lumpy and is tied to a fairly unpredictable cycle of new currency designs. For instance, events like a regime change can be a big positive for De La Rue, as the new government might want to remove pictures of former leaders from the currency. The event-driven nature of De La Rue's business means that in any given year, the firm estimates it is doing a material amount of work for only about a third of its existing customers. As a result, the company doesn't follow a smooth growth trajectory.
Given the maturity of the industry and De La Rue's established presence, we think long-term growth opportunities are fairly modest. We do think the company can grow a bit faster than the overall growth rate in banknotes, as smaller countries are increasingly drawn to outsourcing their currency design and production because of the favourable economics. De La Rue estimates that the number of banknotes outsourced has grown from 8% to 15% over the past 20 years, and we don't think that this trend has fully played itself out. Still, over time, growth averaging in the mid-single digits is about all that we think can be reasonably expected.
Valuation
Our fair value estimate is 910p per share. We expect only modest growth for De La Rue, although annual results might vary because of the event-driven nature of much of its business. The revenue compound annual growth rate over our five-year forecast is 5%. In recent years, most of the company's growth has come from outside Europe and the Americas, as smaller countries move towards outsourcing currency functions because of the favourable economics. We expect this trend to continue. While profitability improved once De La Rue sold its cash systems segment, the firm has also been benefiting from a positive mix of business of late. As such, we forecast operating margins to track downward slightly in the near term, but over time believe that the natural scalability of the business and the company's cost-control efforts should lead to modest margin improvement. We expect operating margins to reach 19% by the end of our forecast period, up from 17% in fiscal 2009.
Risk
De La Rue's results can be difficult to predict year to year, given the event-driven nature of many of its services. The company operates around the world, creating currency, cultural, and political risks. De La Rue's reputation is critical to its competitive position and it handles highly sensitive products. Any breaches of security could severely affect its business.
Management & Stewardship
De La Rue recently initiated some changes in its management ranks, as it wrapped up changes it was making to the operating structure and focused its efforts squarely on its government-based businesses. James Hussey, a 25-year veteran at De La Rue, took over as CEO in January 2009. Over the past few years, management has been focused on streamlining the business so that its segments all served a common customer base. The largest move in this direction was the divestiture of the cash systems segment in fiscal 2009. This business, while somewhat related to its core operations, served banks as opposed to governments. We think the move to focus De La Rue on its strongest areas is a positive. We also like that management returns the bulk of its free cash flow to shareholders in the form of dividends and stock repurchases. The business is not capital-intensive, and acquisitions don't make much sense strategically, given the nature of the business, so we believe that this is the best course for the company.
Overview
Growth: Growth historically has been somewhat lumpy, given the event-driven nature of the many of the company's services. Over the long term, we expect only modest growth, given the company's established presence in its market and low growth rates for banknotes.
Profitability: De La Rue is solidly profitable. Margins rose recently because of the divestiture of a lower-margin segment and a positive shift in product mix. We expect margins to tick up slightly over time thanks to the scalability of the business and cost-control efforts.
Financial Health: Solid profitability and limited use of debt leave De La Rue in good financial condition. An unleveraged balance sheet allows the company to return most of its free cash flow to shareholders.
Profile: Based in the UK, De La Rue offers services that centres on the design, printing, and handling of currency and security documents. The company is a leading player in its industry and has relationships with 150 countries. De La Rue employs 4,000 people in 24 countries.
Strategy: The company has made moves to streamline the business lately and sold a large segment in fiscal 2009 that provided cash handling services for banks. While the two businesses were somewhat related, management decided to sell this operation because of the different customer base.
Bulls Say
1. The need for a secure currency that thwarts counterfeiting efforts has increased. This move toward increased sophistication in currency design can only help increase demand for De La Rue's services.
2. Although economic conditions are a factor in banknote demand, other factors such as design cycles and cash circulation policies play a much bigger role. As a result, De La Rue's business is not highly sensitive to the state of the global economy.
3. Management has demonstrated its commitment to returning the company's ample free cash flow to shareholders.
Bears Say
1. Given the slow growth in the volume of banknotes and De La Rue's established market presence, growth opportunities are limited.
2. The trend toward credit and debit cards and away from using cash could be a long-term drag on De La Rue's results.
3. The event risk of security missteps is ever present, and any mistakes could be costly, given the importance of a rock-solid reputation in De La Rue's business.
