Monotype Imaging: Short On Unrealistic Optimism

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By Preston Bryant ’19, David Xu ’20, Cade Zawacki ’19

Carnegie Mellon University-Tepper School of Business

Investment Thesis:

Current Share Price (as of 3/10/2017): $19.50

Projected Share Price: $16.03

Thesis: Monotype Imaging Holdings (NASDAQ:TYPE) is an ideal short candidate due to its weakening monopoly over the font industry; paired with a management team overly optimistic about growth opportunities in the consumer devices segment while also failing to adequately acknowledge the risks of being overly exposed to declining printer sales.

Company Overview:

Monotype Imaging Holdings Inc., headquartered in Woburn Massachusetts, is a provider of typeface and text display technology for use by creative professionals and technology that is embedded in consumer devices. In the words of the company itself, Monotype “brings the world’s words to the page and to the screen.” With a growing library of over 20,000 typefaces, including widely used classics such as Helvetica and Times New Roman, Monotype aims to facilitate creative expression and to help global brands connect more personally with their consumers through a recognizable voice and a distinct public image; servicing clients across the world and across all sectors: a notable few being AT&T (NYSE:T), CVS Pharmacy, Goldman Sachs (NYSE:GS), IBM (NYSE:IBM), Nike (NYSE:NKE), Pepsi (NYSE:PEP), and Target (NYSE:TGT).

Business Model:

As a marketer may advise, choosing the right typeface and font for a logo or website is often a key factor separating what becomes a successful design from something that is ignored or overlooked. To delve briefly into technical definitions, a “typeface” is an agreed design scheme for a set of characters used to compose text (in layman’s terms, for example, the shape of the letter A), whereas a “font” is a computer file describing to a system how certain characters should be displayed either on a screen or to be printed out onto a page. Via the 1976 Copyright Act, typefaces themselves are not recognized as intellectual property in the United States and, therefore, are not protected under any copyright or patent law. However, fonts are considered to be a piece of software, and are, therefore, protected. This enables Monotype to generate revenue by licensing use of its fonts to content creators. Historically, Monotype found business by designing fonts that were specially optimized for smooth processing and scalability as to maximize readability – particularly on small-screen and low-resolution devices, where other (generally free) font alternatives tended to distort and become hard to read.

Monotype sells its fonts to large corporations such as Microsoft (NASDAQ:MSFT) and Adobe (NASDAQ:ADBE) through long-standing contractual licensing agreements, and also to individual consumers via its many e-commerce websites such as myfonts.com, fonts.com, fontshop.com, linotype.com, and fontfont.com. For many years, Monotype enjoyed essentially operating a monopoly as the only major online font provider. This industry domination, however, has recently become challenged as Google (NASDAQ:GOOG) (NASDAQ:GOOGL) continues to expand its free font offerings and online communities have emerged (such as Behance, recently purchased by Adobe) as platforms for independent designers to easily sell or give away their fonts. This increase in competition has recently begun to materialize with Monotype missing its earnings and revenue expectations by significant margins over the past two quarters: most recently with a -37.8% surprise on February 17, 2017.

Industry Overview:

Monotype is a part of the software licensing and monetization (SLM) industry. When Monotype licenses its fonts to firms, the firm must also have the technology to support the font in its device. For example, with laser printers, it must be able to recognize the font from the computer and then reproduce it in writing, with both processes requiring software from Monotype to do so. SLM enables software publishers and intelligent device vendors to efficiently monetize their products, particularly, for enterprise and networked deployments. Client-side enforcement can be done using hardware keys or dongles from within the software or through the cloud. Electronic enforcement is growing faster than hardware-based enforcement. Usage-based licensing is the fastest growing application for software monetization solutions.

Industrial automation is the fastest-growing application within the embedded segment, with healthcare and automotive also showing promise. Usage-based licensing is a key trend in the software monetization market as customers gain increasing say in how they want to consume and pay for their software. North America and Latin America (NALA) have overtaken Europe, the Middle East, and Africa (EMEA) as the strongest regional market. Asia-Pacific (APAC) is also growing, driven by growing publisher revenues, cloud-based deployments, and aggressive global expansion by publishers. The SLM market continues to have fewer than 10 key vendors. Revenue in 2015 narrowly exceeded $300 million. The forecasted CAGR from 2015 to 2022 is 6.0%. (Frost and Sullivan). Below is the current breakdown in the software licensing industry in terms of market share:

 

A key item to note is that Adobe Systems, a key competitor for Monotype, has a 5.19% market share in the industry. In addition, comparing across countries, US SLMs are typically more mature than their foreign counterparts. Look below to see a graphic ranking by geographical region the life cycle of SLMs:

Catalysts Supporting a Short:

1. In the type industry, it has been established that Monotype has historically operated with a monopoly. Major software and technology companies such as Google, Adobe, and Microsoft (Office Suite), along with large-scale print publications such as The Economist and Pearson relied on Monotype for font solutions. Compared to its closest competitor (Adobe), Monotype owns approximately nine times as many fonts and is considered to be more widely used (Economist). As evidence to this, Monotype owns seven of the 10 most popular fonts used on Microsoft Office (Microsoft). Designers throughout the industry, such as Erik Spiekermann, even went so far as to say “Will Monotype Imaging be renamed Monopoly Imaging?” since it has been so dominant in the font space. Yet, Monotype’s historic dominance in this industry has recently begun to dissipate. The reason for this is that there has been a flood of new entrants in the space who have been offering free font alternatives. The arrival of these free fonts started to appear in 2010, most notably from Google. What has been challenging for Monotype is that many of the fonts Google owns are popular and free, which incentivizes developers and companies to look toward these fonts rather than Monotype’s pricey Font Library. The graphic below describes the key differences between Google and Monotype:

Even CEO Scott Landers has acknowledged that the dominance within the font space is diminishing. He recently said, “I think it was always a big section, it’s the largest section of that market, which was kind of the free one, right. And then kind of Google always had it and probably always will”. In addition to Google attacking Monotype’s monopoly of the industry, Microsoft’s default font shift also puts into question Monotype’s popularity and font recognition. Microsoft has been proactive in the font space, creating popular fonts such as Calibri and Cambria. These fonts replaced Times New Roman as the default fonts in Microsoft Suite 2007 (Microsoft). This has caused many institutions to move away using Times New Roman (since it is not the default) as well.

2. Throughout Monotype’s earning calls and other financial filings, there has been a consistent trend of pointing toward entry into the automotive industry (as navigation system and control system font types). For instance, in the Q4 2016 earnings call, current CEO, Scott Landers, pointed out that automotive industry is being looked to for growth in a declining OEM business burdened by their laser printing clients. However, looking at the current state of the automotive industry in addition to Monotype’s penetration and added revenue in the industry suggests that this will not be the engine of growth that will carry the struggling OEM business as Monotype management suggests it well. Back in its Q2 2014 earnings call, Scott Landers shed some light on Monotype’s goals for this industry – summarized in the following tables:

Key
*=Estimated
2013201420152016
Profit Per Car$.5$.51*$.51*$.52*
Total Number Cars TYPE is In6,000,0009,803,922*9,814,398*9,824,875*
Total Car Revenue$3,000,000$5,000,000$5,005,343.21*$5,108,935*
Total Market Penetration9.17%14.52%*14.31%*20%

Note: The most important number in this table (2016 Total Car Revenue) was derived by increasing 2013 Profit Per Car by the rate of inflation and using information found in Q4 2016 earnings call and using information provided by OICA

The table points out that Monotype presence in the automotive market is still in its infancy. In the words of CEO Scott Landers: “our current customers represent approximately 70% of the total unit shipped. We believe that we’re now 20% penetrative within our current customers, which leaves us with a meaningful opportunity to expand within existing accounts” (Q4 2016 earnings call). Landers, back in Q2 2014, stated that Monotype’s ultimate goal is to achieve 100% market penetration: an opportunity, he thinks, will create an additional “$20 million revenue stream” (Q2 2014 earnings call). According to the profit Monotype received per car in 2014, in order reach this figure, Monotype would have to enter approximately 39,215,686 cars; a 299.15% increase from its 2016 estimates. In short, management thought that automotives had the potential to increase total revenue by about 10% while helping the struggling OEM revenue segment (which accounts for 50% of total revenue) by about 20%. While Monotype does work with Tier 1 automotive companies (ex. Ford (NYSE:F), Porsche (OTCPK:POAHF), GM (NYSE:GM), etc.), the emergence of ride-sharing companies such as Uber (Private:UBER) and Lyft (Private:LYFT), along with concerns regarding how autonomous cars will affect consumer automotive purchases, creates uncertainty about revenue growth in this segment. These new disruptors are delaying car purchases according to a CNBC poll from 2015: “The real potential challenge to auto sales came from the survey’s second question, which asked whether Uber users would reconsider the purchase of a car specifically because they use Uber. According to the survey, 22 percent of Uber users aged 18 to 64, who have used the service in the past six months, said they were delaying or holding off buying a new car for that very reason” (CNBC). This, in addition to fears that the auto sales in developed countries such as the United States and the European Union will retreat from six-year highs, constitutes concern as to whether car manufacturers will continue to produce at their current volume (New York Times). This concept is summarized in the table below:

Note: Data collected from OICA. On average, Cars Made exceed Sales by 1,741,765 and both were correlated with one another with an R^2 of .99.

With the sale of cars being highly correlated to the number of cars produced, paired with the increasing popularity of ride-sharing and stalling car purchases, the demand for automobiles is poised to slow down. As such, management is overly optimistic on automotive revenue for this year and failing to meet expectations will likely have a negative impact on its share price.

3. A major component of Monotype’s revenue comes from OEM sales – accounting for around 50% of its business. This massive dependency on OEM sales creates a huge risk for Monotype moving forward – especially as revenue from this segment has been declining: in 2015, Monotype’s OEM segment saw revenue fall by nearly 3%. Underlying this negative trend is the weakening sales of laser printers that embed Monotype’s font technology; making up around 30% of Monotype’s total revenue.

As evidence of this slowdown, the International Data Corporation (IDC) estimated that global printer sales slumped by almost 11% year over year in 2015. Furthermore, the CEO of Hewlett Packard (NYSE:HP), a company largely dependent on printer sales, commented on HP’s declining revenue by stating that the printer market continues “to be challenging,” reiterating the company’s weak outlook for 2017. Despite this, Monotype’s current CEO and president, Scott Landers, has yet to fully acknowledge the risk of being overexposed in this department – instead citing printers as a long-term growth opportunity on the speculation that sales will pick back up.

Monotype has tried to combat declining printer sales with optimistic prospects for growth in other segments such as GPS, digital camera, e-readers, wearable tech, and even virtual reality. The increasing usage of smartphones, however, as solutions for these segments represents a major concern for the future potential of Monotype’s imaging technology as FreeType, a free open source text render that is very actively managed and updated regularly, almost exclusively handles visual displays on Linux, iOS, Android, and ChromeOS devices. In addition to this, there has been a recent increase in the popularity of voice-commanded devices such as the Amazon Echo (NASDAQ:AMZN) and Google Home which, by their design, do not require any text interfaces. As these two trends continue to expand and perhaps even accelerate, Monotype will become less relevant.

Over the past two years, Monotype acquired two early-stage, digital marketing companies, Swyft Media and Olapic, for together around $157 million. These purchases were an attempt by management to diversify Monotype’s revenue streams away from its traditional font niche and into the branded engagement arena – which, however, is an incredibly competitive industry. Olapic, for example, had negative income before its acquisitions, and has continued to destroy value under Monotype.

4. Monotype primarily operates within the United States, the United Kingdom, Germany, and Japan. As such, a large portion of its revenue (43.8%) is exposed to foreign currency risks. The general consensus is that interest rate increases in the United States (several analysts are stating that it is possible for up to four rate hikes this year), paired with the possibility that the Trump administration will adapt isolationist economic policies, will continue to strengthen the value of U.S. Dollar – which, in turn, would diminish the value of Monotype’s foreign sales.

Company Valuation:

To provide a valuation of the company itself, we created a Discounted Cash Flow for Monotype. However, since we are advocating a short position, the following valuation model utilizes growth projections that are optimistic compared against industry averages.

Since 2013, Monotype’s EBIT growth has been quickly declining, falling from its then growth of 6.52% to the current decline of -36.16%. Before 2013, however, Monotype had seen consistent EBIT growth, reaching a peak of 21.63% growth in 2010. With its new plans to expand into the automotive and virtual reality markets, while simultaneously detracting from the OEM sector, we are giving Monotype the benefit of the doubt and projecting positive growth for the coming years. In its prime years, the average growth rate was approximately 12%, so we assume the optimistic growth rate of 12%.

Depreciation & amortization and capital expenditures were left relatively unchanged throughout the years because, historically, aside from minor fluctuations, the two values did not change significantly. Capital expenditures did spike in 2014 and 2015 due to the acquisitions of Swyft Media and Olapic, but these values are outliers. New acquisitions would result in similar capital expenditure spikes and create a lower valuation. We, however, assumed Monotype will not make any new acquisitions in the following years.

The projected values for net working capital were based off of an exponential function modeling the historical changes in working capital recorded in Monotype’s annual reports. Net working capital tended to fluctuate, but primary characteristic is that the magnitude of its changes has been consistently decreasing, tending closer to 0% change.

Finally, if looking at its balance sheet, it can be seen that in the previous years, Monotype did not have any long-term debt. The sudden jump to $105 million in debt, as stated in its annual report, was due to a large loan taken out to pay for the acquisition of Olapic. However, Monotype also has $91 million in cash reserves, so its net debt is $14 million.

Using both the perpetuity growth and EBITDA multiple methods, we have come up with the following valuations:

The weighted average cost of capital (WACC) was determined to be 12.03%. This was found by taking the weighted average of the cost of holding equity ((CoE)) and the cost of holding debt (CoD). The former is found by using the Capital Asset Pricing Model while the latter is set as the interest rate on Monotype’s line of credit. The two result in a CoE weight of 11.49% and a CoD weight of 0.54%, resulting in 12.03%. To encapsulate variation in the WACC, we determined the price ranges from 11.5% to 12.5%.

Both the terminal EBITDA multiple and perpetuity growth rate were set higher than the current multiples. In an optimistic sense, the company would continuously outpace its current performance, causing the multiples to rise.

However, even with such optimistic measures in the DCF, the share price hovers around approximately $15.50-16.50. This valuation is far below Monotype’s current share price, implying that the stock is overvalued.

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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.