De La Rue (DLAR) is a long-established leader in its industry. While that's a good thing for any company, it is especially good for De La Rue. The company's business centres on the design, printing, and handling of currency and other security documents. The products De La Rue deals with are obviously highly sensitive, making an established record crucial, as the risk governments would face in dealing with unproven vendors is too great. This insulates the company from competition, and we think a wide moat surrounds the business. Recent production issues will negatively impact the business in the short run, and could lead to the loss of a major customer, but we think the company's moat will remain intact. On the positive side, the company's problems have led to an unsolicited bid from competitor Oberthur, this could put a floor on the stock until the company moves past the production issues.
Fair Value Estimate: 844p ¦ Uncertainty Rating: High ¦ Economic Moat: Wide ¦ Stewardship Rating: B
Thesis (Last updated January 11, 2011)
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 hasr elationships 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 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 midsingle digits is about all that we think can be reasonably expected.
In the near term, though, recent production issues will negatively impact the business. After an investigation, it was found that employees deliberately falsified some paper specification tests and production was temporarily halted. However, these issues are more production-oriented, in our opinion, and the currency in question was not comprised. A security breach would have deep implications for the company given the importance of reputation to the business, but we think this event doesn't rise to that level.
Valuation, Growth and Profitability
Our fair value estimate is 844 pence per share. We expect only modest growth for De La Rue long-term, 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 2%, with a double-digit decline in the revenuet his year and mid-single-digit growth once the company moves past its production issues. 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 favorable 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. Additionally, the production issues will likely have a major impact on margins this year. As such, we forecast operating margins to drop this year, but then rebound toward more normalised levels, and track up slightly over time as the natural scalability of the business and the company's cost-control efforts should lead to some modest margin improvement. We expect operating margins to reach 18% by the end of our forecast period, on par with the average level over the past three years.
Scenario Analysis
Our downside scenario results in a fair value estimate of 539 pence. In this scenario, we assume the impact of De La Rue's production issues is deeper and longer lasting. Under this scenario, the 5-year revenue compounded annual growth rate, or CAGR, is negative 3%, with revenue falling almost 25% during the next two years, and only growing at a low-single-digit growth thereafter. We also assume in this scenario that margins fall off slightly over the next five years, to 15%, because of the lack of top-line growth and an unfavourable mix shift.
Our upside scenario results in a fair value estimate of 1,192 pence. In this scenario, we assume the company moves pasti ts production issues quickly, and high single-digit growth in the back half of our projections results in a revenue CAGR of 6% over the next five years. As a result of this growth, the company is better able to leverage its cost structure, and operating margins steadily improve to 21% over time.
Economic Moat
De La Rue's established reputation and its scale are the foundations of its wide moat. The products De La Rue deals with are obviously 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 dominated by a few large global firms. De La Rue believes it is the largest global player, and has relationships with 150 countries. The firm can take advantage of its scale efficiencies to offer its services at a substantial discount to the cost countries would incur in doing it themselves, but still at a price that locks in economic rents for De La Rue. We also think that the company's business model, while a bit lumpy and event-driven, is somewhat self perpetuating. Companies like De La Rue design new security features to thwart counterfeiters, who then try to work around these features, which leads to a need for new security features, and so on.
Moat Trend
We think De La Rue's moat trend is stable. With only a few global players in the industry, competition is muted. The biggest risk to De La Rue's moat is irrational competition among the dominant players, or a blow to its reputation. The company's recent production issues raise a flag on the second point, but as the security of the currency wasn't compromised, we don't believe that this problem is serious enough to permanently impair the company's moat.
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.
Capital Structure
De La Rue carries only a modest amount of debt, and debt/EBITDA was only 0.8 times at the end of fiscal 2009. We don't expect this situation to change, as the business is not capital-intensive, and the company is not acquisitive. The company did increase debt slightly to pay a one-time dividend associated with its divestiture of the cash systems segment. We view this more as a one-time event, though, and not the beginning of a trend toward a more debt-heavy capital structure.
Enterprise 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. The company's production issues create event risk in the near term, and could lead to lost customers. As a result, we have increased our uncertainty rating to high until we have have a firmer grasp on the implications.
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. His reign was short, though, as he recently resigned in the wake of the production issues the company experienced. The company has brought in Tim Cobbold as the new CEO. Cobbold comes to De La Rue from Chloride Group PLC. While Cobbold's lack of experience in the industry could be seen as a negative, this is somewhat understandable as there were most likely few external candidates that did. 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.
Bulls Say
1. The need for a secure currency that thwarts counterfeiting efforts has increased. This move towards 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.
4. Oberthur's unsolicited bid for De La Rue validates the value of the franchise, and might put a floor on the stock until the company can work through its production issues.
Bears Say
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. Any mistakes could be costly, given the importance of a rock-solid reputation in De La Rue's business.
4. There is speculation that De La Rue could lose India, the customer affected by its production issues. This would be a material blow.
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