Communisis (CMS): First mover advantage

I bought Communisis (LON:CMS) after much dallying back in 2011, a choice that's proven to be rather fortuitous - the share price has roughly doubled in that time as the business has gone from strength to strength. Investor opinion on Communisis seems to have shifted from it being a unspectacular company in a dead-end industry to being an exciting multi-channel growth prospect. Frankly, the drivers of the revaluation of the business weren't really ones I fully grasped at the time, but in hindsight I think this was another case of the headline figures hiding the real growth prospects. The bulk of revenue coming from direct mail made the marketing and communications business as a whole look decidedly old hat, and disguised the fact that the newer, integrated segments are actually both extremely profitable and very fast growing.

That is, I suspect, no longer a problem. Even just reading the media coverage you get a sense of a company which is now viewed in a different way; FT coverage opined that 'its universal approach and trusted brand - after years of printing cheque books and regulated financial material' helped to contribute to some of the recent success. Of course, this is all secondary and largely irrelevant. The one truest indicator of popular opinion is the market price. At least by the simple metrics, Communisis surely isn't looking as cheap any more; so my question is, after their results a couple of days ago, is there further to run or are we approaching the hopeful growth price territory?

The results

It's easy to see why there's a bit more interest given the results - operating profit is up 23% pre exceptional, margins continue their upward march and now sit at 6.5% (the CEO reckons they can get 10% in a few years) and headline revenues are up 10%. There's good specific tidbits, too - overseas revenue and revenue from non-financial services companies are both up, which might indicate a stronger business as both of these represent diversification away from their core. If you're wondering about future growth, management give a hint as to their opinion on that with their recent capital raising - they raised £20m gross in a share issue, which apparently will be used for 'restructuring costs, small acquisitions and working capital'. 

Given the returns the company earns on its capital - over 25% average for the last 3 years, which ostensibly are the 3 post-restructuring years, any growth is excellent for shareholders. Indeed, given the fact that the company is supposedly still not operating at full capacity and currently utilises only about £50m of operating assets, £20m if invested to earn the same return the rest of the business currently is represents a good deal of added value. That might even be an understatement given where the investment would fall - on the higher return, higher margin segments. Clearly, there looks like more to run.

The valuation

The problem I have is valuing a company like this. Put simply - I don't do it much. Running the sums shows you that majority of Communisis's 'value' is in future growth expectations and not their current operations - in a no growth scenario I think Communisis is substantially overvalued. The problem is probably easiest to understand if you think of it terms of returns. Communisis earns great returns on operating assets. As a result, it's obvious that if they can utilise more assets to that degree of productivity - by winning contracts, buying contracts through acquisition etc. - their value will be powerfully compounded. At the same time, this makes one factor of your analysis critical - where do you think returns will be in 5-10 years time? The key factor in that, in a case like Communisis's (who currently earn well above their cost of capital) is whether you think they have a sustainable competitive advantage.

The FT hinted at one possible answer - they have long standing customer relationships (which is true), combined with the trust factor inherent in the fact that big companies like dealing with one firm when talking about their confidential, business-sensitive data. Really, though, I wonder if Communisis have just been quicker off the bat, and management has been better at forseeing what was going to happen than their competitors. That's a first-mover advantage story; they were the first to install huge colour presses for more individualised and premium printing, for instance, and it's hard to argue that they don't have a big edge on their competitors with the volume of contracts they seem to be winning on a monthly basis.

The crux of that issue is sustainability. If we accept they've 'won' because they've moved first, what happens next? Do returns decay from an exceptional level to something more normal in the mid term as other companies catch up? Will those relationships cement Communisis as a market leader and allow them to build their fort and dig the moat around it? Extremely high levels of reliability seems to be the key in this game, which ought to lend itself to bigger suppliers.

The difference in those outturns is enormous for the valuation of the business.