Value Play: Harte-Hanks (NYSE: HHS)

One of the most famous sayings in business is “change or die.” Those companies that can adapt their products and services to changing customer needs are those that succeed, whereas those that can’t adapt (e.g., buggy whip manufacturers) cease to exist. Marketing services company Harte-Hanks is one of the adaptable winners that has constantly changed with the times as need be.

Founded in 1923 by partners Houston Harte and Bernard Hanks, the company started out as a publisher of small-town Texas newspapers. In the 1970s, television stations, radio stations, and cable systems were added to the mix to create a diversified media company, which at its peak included 74 different newspapers. The company went public for the first time in 1972 to fund this media property expansion, but went private again in 1984 thanks to a leveraged buyout (LBO) led by the Harte and Hanks families. To pay down debt incurred as part of the LBO, the company sold off most of its broadcast stations, along with many of its weaker newspapers, focusing more on its new and growing shopper local-advertising pamphlets and direct-marketing businesses. In 1993, the company went public again, this time for good. In 1997, Harte-Hanks divested the last of its newspapers and television stations and became a pure marketing company. The reason according to then-CEO Larry Franklin:

We have tried to keep our company on the leading edge of where we see the media business growing. Newspapers are a more mature business, with less hope to match the strong revenue growth expected in the remaining segments of Harte-Hanks.

Whereas newspapers and broadcast stations were mass-market advertisers, shoppers local advertising and direct marketing is targeted to sub-segments of customers that are more likely to buy the products in question. Harte-Hanks correctly predicted that the future belonged to higher-growth “target” marketing which, with the advent of big-data analytics, is now called “smart” marketing.

Despite all of this change, the company has never forgotten to return capital to its shareholders (slide nos. 23-24). Since at least 1995 the annual dividend has never declined. It didn’t get cut during the 2001-03 recession, nor did it get cut during the 2008-09 financial crisis. A cursory review of the company’s dividend history will discover that the annual dividend in 2013 was lower than in 2012, but that was simply due to the company accelerating the first-quarter 2013 dividend into 2012 because of concerns that dividend tax rates were going to rise. The quarterly rate remained constant between 2012 and 2013. The current annual dividend of $0.34 per share translates into a dividend yield of 5.0%, which is very high for a small-cap stock that consistently pays a fixed dividend. The company has also repurchased more than $1 billion worth of its own stock since 1997 and this past August announced a new $20 million share repurchase program, which represents 4.7% of total shares outstanding. Since 2004, the company’s share count has declined 28.4% from 88 million shares to 63 million shares, which means that each remaining share represents a larger stake in the business – a good thing.

The past two years have seen Harte-Hanks continue to change for the better with a new management team and the divestiture of the slow-growth, non-core shoppers business segment:

• December 31, 2012: Sells Florida Shoppers (The Flyer)
• July 1, 2013: Chairman and CEO Larry Franklin retires after a 40-year career at Harte-Hanks, with the CEO and Chairman positions now split between CEO Robert Philpott and Chairman Christopher Harte, who has a newspaper background and is the nephew of former Chairman Houston Harte (60-year career), the son of the company’s founder Houston Harte Sr.
• September 27, 2013: Sells California Shoppers (PennySaver), completing the divestiture of the shoppers division.
• May 27, 2014: Philip Galati appointed new CEO of Trillium Software, the big-data analytics division of Harte-Hanks and the biggest driver of new growth.

Divesting the shoppers division was a huge move for Harte-Hanks given that the division represented 25% of the company’s revenues. Shoppers are weekly advertising publications, contain approximately 32 pages that are 7 by 10 inches in size, and are distributed free by USPS saturation mail to households and businesses in a particular geographic area. Although the shoppers division had generated significant revenue, it wasn’t consistently profitable and had become much less valuable that it used to be prior to Internet search engines. As a result, the company took a monstrous impairment charge in the second quarter of 2012 of $1.87 per share that ruined the entire fiscal year. 

It’s better to generate less revenue if it means a more profitable company that can devote more attention to higher-growth businesses . . . like the Trillium Software division, which analyzes a company’s big data for insights into customer buying habits.  While Trillium currently contributes only about 10 percent of total company revenues, it generates 34% of the company’s operating income (pp. 24-25) and is the future of the company.

Harte-Hanks Two Business Segments

Source: Q3 2014 Company 10-Q (page 18)

Digital marketing is the future of the customer interaction division, which means using PCs, smartphones, tablets, and gaming consoles to deliver the advertising message rather than traditional channels of advertising like newspapers, direct mail, and broadcast stations. Whereas revenues for traditional channels of marketing are expected to grow 6.8% between 2012 and 2016, digital marketing revenue is expected to grow eight times faster at 54.3% (slide no. 9).

As for Trillium’s big-data software, its technology is best-in-class, as seen by Bloor Research’s April 2014 characterization of Trillium as “significantly ahead of competition for Data Quality, Data Discovery and Data Cleansing.” Equally impressive is Trillium’s positioning as a leader within Gartner’s “Magic Quadrant Box” for data quality tools for the 8^th consecutive year. Trillium’s new CEO Galati worked at IBM, which Gartner also positioned as a leader in data quality tools, so he has the expertise and experience to keep Trillium on top. General Electric CEO Jeffrey Immelt has called big-data analytics the “next holy grail” for business, and Trillium has an opportunity to ride the big-data megatrend to greatness.

Thanks to the growth drivers of digital marketing and Trillium, Harte-Hanks has the potential to return to its glory days as in industry-leading marketing firm. Hard to believe now, but it once was a great growth stock, having beaten the return of the S&P 500 by more than three-fold between 1997, when it first announced that it would be selling its last newspapers, and 2005. But 2005 was the top. Subsequently, the stock stagnated for two years before collapsing during the 2007-09  recession and bear market. It has never recovered (so far). Revenues are half what they were eight years ago at the fiscal 2006 high and earnings are about one quarter. At its current price of 6.83, the stock is trading at the same level it was 19 years ago in 1995.

If Trillium really takes off with the big-data megatrend, the stock could conceivably make it back up to its previous price high of 31.47 in June 2005. Reading some of the employee reviews on Glassdoor.com for both the parent Harte-Hanks and the Trillium subsidiary, one can’t help but feel a sense of excitement about the new management team and what they can accomplish. My investment thesis does not depend, however, on the company becoming a market leader again. In fact, I don’t need much capital appreciation at all; what impresses me the most about Harte-Hanks is its commitment to a sustainable dividend that has never been cut in the past 19 years. The Roadrunner Value Portfolio needs a solid dividend-payer and Harte-Hanks is it!

The restructuring and future growth potential is merely icing on the dividend cake. The stock’s valuation on a price-to-book and price-to-sales basis is about the lowest it has ever been. Even on my favorite valuation metric of EV-to-EBITDA, the company is trading only at 8, which is within the “cheap” range. Looking at the balance sheet, debt is reasonable at only 20.2% of total capital and operating income (EBIT) covers interest payments 14 times over. Looking at the income statement and the statement of cash flows, the ratio of cash flow to net income has consistently been above 1.0 for several years, which is evidence of earnings quality. Quality earnings are sustainable, which leads to sustainable dividends. Bottom line: Harte-Hanks is a solid company with a sustainable dividend. The only thing missing is growth, which the company plans to jumpstart by spending $200 million on acquisition targets in the next 2-3 years and has a goal of doubling revenue to $1 billion within five years (slide no. 27).

I’m a big fan of founder-family-run businesses and Chairman Christopher Harte ensures that the Harte family’s commitment to building a lasting legacy of success at the company remains alive and kicking. Insider ownership at the company is substantial, although the recent retirement of Vice Chairman Houston Harte (10.5% ownership stake) and CEO Larry Franklin (9.4% ownership stake) has caused the insider percentage to decline from 31.2% in 2013 (page 14) to 12.0% in 2014 (page 15). Both retirees still own the same ownership stakes a year later, so the reduction in insider ownership percentage is merely cosmetic and not material.

A company’s value is determined by discounted future cash flows – regardless of whether those cash flows are destined to grow or shrink. Consequently, even a business estimated to experience negative growth over the next decade can be “undervalued” if the current market price falls below these shrinking future discounted cash flows. In his 1989 shareholder letter, Buffett called such undervalued companies “cigar butts” that were so cheap that they were destined to give investors at least one last puff of price-appreciation pleasure on their way to either reigniting growth or stagnating.

Harte-Hanks fits Buffet’s description of a cheap cigar butt because its current cash flows justify a stock price of at least $10, but I believe this cigar butt will succeed in reigniting growth, paying shareholders a 5% yield while they wait for results that could catapult the stock even higher.

Harte-Hanks is a buy up to $8.25; I’m also adding the stock to my Value Portfolio.

Value Sell Alert

To make room for Harte-Hanks, Roadrunner is selling:

• Lydall (LDL)

Lydall is a great company and if I wasn’t burdened by the 20-stock limit on portfolio size, I would be perfectly comfortable holding on to Lydall. But two issues make it expendable: (1) recent insider selling by the CEO is a bit troublesome, especially because it amounts to $3.2 million worth of stock and he hadn’t sold any shares prior to August of this year; and (2) the company’s automobile equipment focus is similar to that of Gentex and for diversification purposes I don’t feel comfortable owning two companies in the same auto-related business. Although Lydall’s EV/EBITDA valuation is cheaper than Gentex, I like Gentex more because its growth is stronger and its HomeLink acquisition makes it more diversified. It was a tough call, but Lydall goes and Gentex stays. It nevers hurts to cash in a profit and Roadrunner has made a nice 61.8% profit on Lydall in the 12 months that the stock has been in the Value Portfolio.

Lydall is (reluctantly) being sold from the Value Portfolio.

Momentum Buy:

1. Taro Pharmaceuticals (NYSE: TARO)

Taro Pharmaceuticals is a pharmaceutical company that develops skin treatments focusing on pediatric creams and ointments, liquids, capsules and tablets, mainly for the dermatological, topical, cardiovascular, neuropsychiatric and anti-inflammatory therapeutic categories. 

• Price gain between 12 months ago and 3 months ago = 53.0% (97th percentile)
• Price gain over the past 2 months = -2.1%
• Price gain over the past month = -10.5%
• Roadrunner Momentum Rating: 53.0 – (-2.1) – (3*-10.5) = 86.7

Taro Pharmaceuticals is a buy up to $175; I’m also adding the stock to my Momentum Portfolio.

Momentum Sell Alert

To make room for the new momentum stock, Roadrunner will be selling the following price laggard: 

• Matador Resources (MTDR)
  
  I still like this Texas-based energy E&P company, primarily because insiders continue to buy the stock and its EV/EBITDA valuation is cheap, but the fact remains that the bear market in energy has crushed the price and it no longer qualifies as a momentum stock. If the Value Portfolio wasn’t already overweight energy, I would have simply switched the company from the Momentum Portfolio t o the Value Portfolio.