Rathbone Income Fund
Update, May 2013
In this exuberant market, we have been trimming some of our positions that have performed well in 2012. When
we made our initial purchases, we felt the market was under-estimating the growth prospects of these businesses: in
other words, the price risk of the investments was low. In spite of their tightened purse-strings, individuals would
still occasionally wander into a William Hill shop and place a bet, or play on one of the slot machines. Individuals
would still want to buy affordable branded foods and beauty products of the sort that Unilever produces, like Knorr
stock cubes or Dove moisturiser. With the benefit of hindsight, it seems terribly obvious, but at the time, these
were contrarian viewpoints. We continue to believe that Unilever and William Hill are high quality businesses
with little balance sheet risk, but the price risk is a little higher than it was in 2012, so they do not deserve quite the
importance within our portfolio today.
Finding under-appreciated businesses in a rising market is difficult, but we have been increasingly drawn to value
investments over those classed as Growth at a Reasonable Price ( GARP ). Recent additions to the portfolio
such as BG Group, Rio Tinto, Lockheed Martin and Ultra Electronics have occurred after periods of share price
underperformance, so whilst they perhaps have higher business risk than William Hill or Unilever, their price risk
has diminished. Another recent value addition to the portfolio is Valassis Communications ( Valassis ), a
business listed on the New York Stock Exchange that is not so well-known in the UK. Our goal is to invest in
businesses that have a defendable market position, that generate cash profits, invest appropriately, have a sensible
balance sheet, but remain overlooked by the market. We offer up Valassis as an interesting case study, that fulfils
our quality, value and dividend criteria, and as such is worthy of our examination.
Valassis came to our attention when it appeared in the top quintile of our valuation screen. Its return on invested
capital ( ROIC ) is high, suggesting a high quality business, but the P/E is low, which might indicate that the price
risk was minimal. Further investigation revealed a company in transition. It was founded in the 1970s in Detroit,
as a business printing money-off coupons for a variety of consumer products companies, initially food
manufacturers. Valassis then paid Sunday newspapers to include their collective coupon insert with their
distribution. Seeking out coupons to reduce the cost of the weekly shop is not usual practice in the UK, but over
$4.5 billion worth of coupons was redeemed in the US last year, the vast majority of which were clipped from
Sunday newspaper inserts. Whilst that business is cash-generative, declining newspaper circulation and
competitive pressure from News Corporation, encouraged Valassis to make a transformational acquisition in 2007.
Over 80% of the group s operating profit now originates from a business that bundles advertisements from local
and regional businesses for delivery by the US Postal Service. What they are selling is relatively inexpensive
advertising, that can be targeted down to the sub-zip code level (making the offering more focussed), or about
3,500 households. Excluding the credit card companies, Valassis is the US Postal Service s largest customer,
which means they receive great service and beneficial rates.
Evaluating the business risks, of the few sell-side analysts who write on the stock, many are concerned by a
perceived threat from technological advances to the coupon business: we are less perturbed. Grocery store
scanners cannot read smart phone screens, and the manual sorting of coupons is easier than doing so virtually, at
least for now. One day there will be a technological solution, but nothing is imminent. Furthermore, this is no
longer the driver of Valassis s profits. Local advertising delivered through the mailbox is not likely to be displaced
by technology. If anything, with local newspapers in decline and technology allowing the user to avoid ads, the
letter slot is probably more valuable than it ever was. We believe that the business risks are more to do with
managing the transition of the business, which is never easy to execute smoothly, but as the only national provider
of bundled print ads, Valassis has a defendable market position.
It is important to us that a business generates cash profits that can support its dividend. When the recession arrived,
Valassis was not only busy integrating the junk mail acquisition but was also coping with rapidly rising newsprint
prices (which it can only pass on with a lag). Despite this, the business still generated free cash-flow after all of its
capital expenditure requirements. In those days, excess cash was used to reduce the debt used to make the
acquisition. Starting in this fiscal year, Valassis has committed to a regular quarterly dividend and to spend a
minimum of 35% of its free cash-flow on share repurchases.
In terms of financial risk, we believe bank-financing is a useful, low-cost source of funding, but must be
appropriate for growth prospects and business risk. We are very comfortable with Valassis s fixed charge cover of
5.8x and that it is using its cash-flow, not increasing debt, to finance its dividend and share repurchase. Since the
business risk of Valassis is higher than for some of our other holdings, we would need the price risk to be low. The
shares are trading on a prospective P/E of 8x, an EV/EBITDA multiple of 5.5x, a free cash-flow yield of 12%, and
have a current dividend yield of 4.7%.
Recent trading: We have continued to take profits from Keller Group and William Hill, as well as Close Brothers
and Cineworld. We have added to Rio Tinto and Royal Dutch Shell on weakness, and have initiated a holding in
Valassis Communications.
Companies seen in April: Howden Joinery, Whitbread, Marstons, SSE, Daily Mail & General Trust, BT, and
Northrop Grumman.
Kate Pettem
Investment Analyst
Rathbone Income Fund
The information contained in this note is for use by investment advisers and journalists and must not be
circulated to private clients or to the general public.