Long Trade Idea - Pollard Banknote Limited

I love researching small and micro-caps because I always seem to find treasure amongst what is perceived as the trash. These businesses are never covered in the media or by analysts, and they are often dirt cheap for a reason. Analytically I find it more stimulating to be able to research these companies than to take for granted what 20 analysts have said about a large-cap bank or oil stock. Risk-reward wise, these small firms also tend to have a lot more upside than larger companies, as evidenced by the small-cap performance advantage discussed in many academic studies.

One of the micro-cap companies that I researched in the summer was Pollard Banknote Limited. I researched it primarily for my own investing purposes, but I also gave a presentation to the Ivey Finance club on why it should be bought. Below, please find the Media Fire link to the PowerPoint presentation, which has audio embedded. In addition, for anybody that does not have the time to watch the presentation, I have done a quick write-up on the investment thesis below that. Enjoy!

http://www.mediafire.com/?gb529c90u9iu52a

Founded in 1907 by the Pollard family (73.3% majority owner), Pollard Banknote (TSX: PBL, $2.50 share price, $16mm float) is in the lottery business. Specifically, Pollard is in three business lines:

1. Instant scratch tickets (88% of revenues) – Pollard produces 10.3bn / annum.
2. Charitable gaming (11% of revenues) – These are essentially pull-tab tickets.
3. Vending machines (1% of revenues) – Vending machines that dispense scratch tickets.

Pollard sells to 45 lotteries world-wide, and generates 56% of its revenues from the US, 24% from Canada, and 20% internationally. They have about 20% market share globally, but 83% in Canada and 20% in the US.

• PBL IPO’d in 2005 as a trust at $10 and has traded down to a low of $2.24. I believe the shares have stabilized at the current level of $2.50. In essence there is limited downside, and I believe this is so because of the cheap valuation and stable business results that it can generate.

• PBL underperformed for five years due to volatile top-line growth, competitive industry pressures, a decline in very volatile earnings, two distribution cuts, a 50% increase in long-term debt since the IPO, and the fact that no research analysts cover it. In short, it is an un-loved, under-followed value stock.

• Since converting into a corporation in May 2010, the dividend is now stable at $0.12 / annum, translating into a 4.8% yield. You are paid to wait for this company to reach a higher, more appropriate valuation.

• Gross margins have always been stable at ~20%. Net margins have fluctuated, but have averaged around 6%. They have trended downwards to about 4% recently. EBITDA margins have stabilized at 12% on a normalized basis. The key take-away? The business is stable, and this is especially so because PBL is part of what is essentially a duopoly in North America.

• PBL trades at 35% of book value and 7x 2010E P/E. It can get cheaper, but I believe it has bottomed based on fundamentals.

• Management rationalized a new $8.5mm press-line installed in 2008 / 2009. It took two years to attain proper efficiencies, so the costs associated with that will no longer be present going-forward. In addition, with the closure of the Kamloops facility, a $4.7mm restructuring charge was assumed in recent quarters, but this will save $4mm in costs per annum in the future. This cost reduction will go directly to the bottom-line and into shareholder’s pockets.

• As capacity utilization is cut (Kamloops), and costs eliminated from the business, growth cap-ex will be cut which will free up the $10-$15mm of free cash flow that the business generates on a normalized basis for debt pay-down. By paying down the $75mm (out of $105mm) credit facility already drawn, the financial / bankruptcy risk of this business will dissipate rather quickly, and I think the market will begin to value PBL slightly higher.

• Taking into account the above mentioned cost-reduction measures, normalized earnings should be around $0.50 / annum. Applying current EV/EBITDA and P/E multiples to the more appropriate forward earnings produces share price targets of $3.40 to $4.00, implying 40% to 60% upside. This does not include contract wins, which are all upside.

• Ultimately, I believe management will privatize the 26.7% of the business it doesn’t own at $3.50 to $4.00, as those are private market values at 7-8x earnings, and represent a 12.5% to 15% earnings yield on the business. Very attractive from an insider's perspective. The final point is that management owns 73.3% of this company. It has been in the family for 103 years. Furthermore, the livelihood and reputation of four Pollard brothers depends on this firm. They will not risk the company by levering it up anymore. Rather, I believe they will take it private and start paying down debt to achieve a higher private-market valuation for the company.