FTD Companies – A free Cash Flow Monster With 50% Upside
|February 4, 2014||Posted by Nat Stewart under Cash Flow Stocks, Compounding Machines||
FTD Companies, Inc. is,
“…A premier floral and gifting company. We provide floral, gift and related products and services to consumers, retail florists, and other retail locations primarily in the U.S., Canada, the U.K., and the Republic of Ireland. Our business uses the highly-recognized FTD® and Interflora® brands, both supported by the iconic Mercury Man logo that is displayed in tens of thousands of floral shops worldwide. Our portfolio of brands also includes Flying Flowers, Flowers Direct, and Drake Algar in the U.K.”
I believe that FTD Companies, Inc. GAAP accounting earnings significantly hide its current economic earnings power, and that the roll-off of a non-economic amortization expense will bring the real earnings of this business to light.
This article will be very tightly focused on the above hypothesis. Investors who are interested in a more broad investment case for the company should read Watkins Capital’s excellent article on FTD Companies, which can be found here.
Last fall, FTD Companies was spun off from United Online, an internet service provider with consistently declining revenues. Pre spin-off, United Online paid a healthy dividend which was significantly funded by the earnings of its FTD Companies florist business. Indeed, FTD companies’ consistent growth was hidden due to United Online’s more rapid revenue decline. The spin-off transaction was somewhat complicated and left many investors confused. United Online split 7 – 1, and emerged as a dividend paying security. FTD Companies, on the other hand, emerged as an independent company with no dividend and no yield. This is significant, because United Online’s high yield is likely what brought many of its shareholders to the stock. The above is important because I believe it sets the stage for why FTD Companies is so poorly understood by the marketplace.
Let’s break down our hypothesis into three steps. First, let’s examine the 2012 (the last full year) income statement.
Notice that net income is around $21 million, and amortization of intangible asset expense is around $25 million. So what is the “Amortization of intangible assets” and does it represent a genuine economic cost? Before we get to this point, let’s examine a table that projects FTD’s estimate of intangible expenses going out to 2017:
Notice that intangible asset expense is more than cut in half in 2014, and almost disappears in 2015. This makes our query into if this is a non-economic GAAP driven expense all the more pertinent. If we find that the expense does not represent a real economic cost, it suggests that not only is FTD Companies’ free cash flow far higher than reported earnings, but that this higher free cash flow will be transformed into reported earnings over the next two years.
Fortunately, FTD Companies provided a table which breaks out what their intangible assets are. Please study the following:
What we see is that the bulk of the amortizing assets are related to United Online’s purchase of FTD Companies in 2008. As stated in the most recent quarterly report:
“Amortization of intangible assets relates primarily to intangible assets associated with the acquisition of the Company by United Online in 2008. Amortization of intangible assets includes amortization of certain acquired trademarks and trade names; acquired software and technology; acquired customers; and other acquired identifiable intangible assets. In accordance with the provisions set forth in ASC 350, goodwill and indefinite-lived intangible assets are not being amortized but are tested for impairment on an annual basis and between annual tests if an event occurs or circumstances change that would indicate the fair value may be below the carrying amount”
The single largest item is “Customer contracts and relationships”. While this might make sense from the perspective of GAAP acquisition accounting, the fact is that revenues and earnings have continued to rise. As such, I believe this expense is an artifact of acquisition accounting and not reflective of a real economic cost. As a side note, Warren Buffett (In the 2012 Berkshire Hathaway annual report) argued that Wells Fargo earnings were clouded by non-economic amortization of customer relationships, which he believes is not an actual expense as business continues to grow. This is effectively the same argument that I am making here.
How has FTD Companies performed so far in 2013? As of third quarter 2013, operating income adjusted for one time separation costs was up about 11%, and sales were up just under 3%. I expect similar results to carry forward for the full year.
I did notice one item that was initially concerning. Cash flow from operations declined substantially as of the last quarterly report; however this was explained as follows:
“Net cash provided by operating activities decreased by $16.0 million, or 52%. Net cash provided by operating activities is driven by our net income adjusted for non-cash items and changes in working capital, including, but not limited to, depreciation and amortization, stock-based compensation, loss on extinguishment of debt and deferred taxes. The decrease in net cash provided by operating activities was primarily due to a $13.6 million unfavorable change in working capital, a $1.7 million decrease in non-cash items, and a $0.7 million decrease in net income. The change in working capital was primarily related to a decrease in accounts payable of $5.7 million related to the timing of payments and a $9.1 million decrease in taxes payable related to timing of tax payments. Changes in working capital can cause variation in our cash flows provided by operating activities due to seasonality, timing and other factors.”
Due to the rolling off of the acquisition related, non-economic amortization (and holding all else equal to show the impact) EPS should rise by close to 75% for the full year of 2015. I believe that this substantial increase in visible earnings will put a substantial tail-wind on the company’s valuation such that all other positive developments (like an increase in real economic earnings) will be icing on the cake.
I estimate that full year 2014 EBITDA – CAPEX will be around 80 Million. With an enterprise value of around 789 million, that represents a cash flow yield of over 10%. This is particularly interesting relative to the borrowing costs implied in the company’s current credit agreement, which are Libor plus 1.5% to 2.25%. The company’s recent investor presentation highlighted the fact that the company has around 130 million of capacity under its current credit agreement.
If (as only present management knows) the sound business performance of the recent past looks likely to continue, I believe that using this credit agreement for a substantial share buyback would be substantially accretive to existing shareholders. In fact, the present undervaluation of FTD Company’s shares creates a significant hurdle for all other investment alternatives, such as an acquisition or even dividend payments. In other words, it might be very difficult for the company to find a better use of cash than its own shares.
One last item of note – Lightspeed Management L.L.C, a very successful special-situation focused hedge fund, recently disclosed (January 13, 2014) that it has purchased a 1.1 million share position in FTD Companies, which is greater than 5% ownership of the company. This suggests that FTD Companies will increasingly be on the radar of other sophisticated investors (including private equity firms) and that the present undervaluation status might not last all that long.
I am setting what I think is a conservative price target of $45 per share, which implies 50% upside from today’s price.