Acco Brands

Historically, one of the interesting places to search for value is off the beaten path. Spin-offs, especially from large S&P 500 companies, tend to provide such opportunities. The rationale is straightforward...

1. S&P 500 companies tend to be contained within index funds,
2. A spun-off company must be sold by the index fund,
3. Large cap funds will sell off small cap spin-offs
4. Little analyst coverage. Too small a market capitalization, too different from parent company's focus, no underwriting relationship, etc

Because of these biases against such companies, the tendency historically has been for them to trade down due to a lot of selling pressure from the large number of initial sellers and to ultimately find a reasonable valuation level.

Acco Brands (ABD) was spun off from Fortune Brands (FO) an S&P 500 company a year ago at this time, August 9th, 2005. Each holder of Fortune Brands received one share for every 4.255 shares of FO common held. Acco is one of the world's largest suppliers of branded office products with products marketed in over 100 countries. The company completed a merger with General Binding in August of 2005 as well. About 85% of its sales come from products in which it holds the #1 or #2 market position and with shares that are often twice or more than the next biggest competitor.

The office products market has been a beneficiary of the growth of the service economy. The large retailers that one would ordinarily associate with this sector (Staples, Office Depot, OfficeMax) have only about 10% of this market, which is very low compared to other destination retailers such as the building supplies or pet supply retailers. One can argue that this relatively low penetration by the mega-retailers should spell greater brand awareness and greater marketing of office products. One can also argue that the mega-retailers' propensity toward private label brands could also hamper margins.

As I mentioned, at the time of the ABD spin-off, the company took over General Binding (GBC). GBC had been under-managed in the past and had operating margins that were only about 7% versus ABD's historical 12%. There is a major opportunity for Acco to integrate operations and focus the product line and hence gain cost synergies.Many of the strategies that Acco has at its disposal for GBC are strategies that the company used in the past. GBC has provided Acco some scale opportunities and consequently some bargaining power. The company has a reputation as an innovator and historically has indicated that about one-third of sales in any year have come from products developed in the prior three years. Gross margins have show improvement at least quarterly, but operating margins remain to be disappointing, at least to me.

The stock has dropped off 5% today which has drawn my attention but is down 26% from its inception a year ago. On an EV/EBIT basis, the company is trading at 15.3 times.

There are about 53 million shares outstanding of which about 15% is held by Lane Industries, a former large minority holder of GBC. Lane has been a significant seller of the stock. Market cap is about $975 million and EV is about $1.80 billion with significant long term debt on the balance sheet as a result of the acquisition and the spin-off capital structure. Interest coverage is about 2.8 times.

The company has generated free cash flow in its very brief public history, last year generating $30.8 million in free cash flow and in the first quarter generating $19.2 million. Return on invested capital is still quite low at about 4.3%. Working capital management has improved slightly with Receivables Turnover at 6.5 times versus last year's 5.1 times and Inventory turnover improvements to 6.9 times versus last years 5.7 times.

In a recent Wall Street Transcript interview with Tim Reynolds of Mallard Capital, (subscription required) he outlines his rationale for selecting this stock.

"This is not an exciting top-line story, as they are a single-digit revenue grower, but they can deliver mid-teens earnings growth. With the stock trading below the market multiple of 16 times, it is a good bet with that kind of earnings growth.Finally, the stock is only covered by a couple of analysts ' another potential catalyst down the road."

I think this is an interesting stock but I await some operating margin improvement before I will use the stock. Debt leverage is high, but if free cash flow generation continues, a much cleaner balance sheet will develop. Earnings growth will come from balance sheet deleveraging as well as from operating margin improvement. I like their strong position in the industry as well as their ability to innovate. Still on the sidelines for now, but looking for a buying opportunity.

Disclaimer: Neither I, my family, or clients have a current position in any of the stocks mentioned above.