FTD is Back in BloomDennis Milton
Rating: 5 STARS (Strong Buy)
With Mother's Day having just passed, moms everywhere are no doubt still admiring floral arrangements sent by their loving offspring. And there's a very good chance that the daisies and dahlias were delivered by FTD Group FTD; recent price, $11). With its Mercury Man logo and nearly 100 years of experience, FTD is one of the largest and most recognizable brand names in the North American florist industry.
Although FTD's main operations have existed since 1910, it was run as a not-for-profit trade organization until 1994. FTD's shares debuted on the New York Stock Exchange following an initial public offering in February, 2005, at $13. FTD shares slumped throughout 2005, due, in our view, to fears that increased competitive pressures in the company's florist segment would significantly narrow operating margins. Furthermore, there were concerns that competition, sluggish regional economies, and more expensive Internet advertising would slow revenue growth in FTD's consumer business.
In March, 2006, FTD shares reached a low of just over $9 per share. However, the stock has rebounded about 25% since then, reflecting strong revenue growth in the consumer segment and improved operating margins in the florist segment in the quarter ended Mar. 31.
Even with the recent price appreciation, we believe the shares have a compelling valuation at current levels, given what we see as FTD's stable and highly profitable base in its florist segment and its strong brand-name recognition. Furthermore, we believe that both the florist and consumer segments are well-positioned to benefit from the rapid migration of floral orders to the Internet.
Finally, we are impressed with the FTD's strong free cash flow generation. We think cash flow from operations should be considerably in excess of capital expenditure requirements over the next several years, allowing FTD to reduce debt and repurchase shares. Our recommendation on the shares is 5 STARS (strong buy).
The FTD label enjoys 96% brand recognition among the company's target market of U.S. consumers between the ages of 25 and 64, according to company research, and its logo is displayed in approximately 50,000 florist shops globally. The company operates through two business segments -- florist and consumer.
The florist segment, which accounted for 44% of total revenues and 82% of income from operations in the first nine months of fiscal 2006 (the fiscal year ends June 30), provides a comprehensive suite of products and services to enable FTD members to send and deliver floral orders. These services are provided to the company's network of nearly 20,000 independent florists throughout the U.S. and Canada.
Qualifying florists are provided with access to the FTD brand name and logo. They also are supported by national advertising, clearinghouse services between members, a quarterly directory publication of members, and credit-card processing and e-commerce site-development services. FTD also sells and leases software and hardware that allows members to transmit and receive orders and provides full back-end systems to manage a florist's business.
The company also provides a Linux-based network that links FTD members, allowing them to transmit and receive orders among themselves. In addition, FTD operates as a wholesaler to network members of branded floral arrangements, greeting cards, packaging, and promotional products.
The consumer segment (56% of revenues and 18% of income from operations) is an Internet and telephone marketer of flowers and specialty gift items to consumers. The company offers floral arrangements and specialty gift items, including holiday gifts, wine and gift baskets, and stuffed animals, with delivery by common courier. In fiscal 2005, FTD fulfilled approximately 4.1 million retail orders, with an average price of $60.67 per order.
The company does not own or operate any retail operations, and therefore does not bear the burden of maintaining physical inventory or the costs of warehousing and distribution facilities. Orders are instead routed through local florists that are members of the company's florist network, or, in the case of specialty gifts, through third-party manufacturers and distributors. Specialty gifts accounted for approximately 29% of all consumer orders in fiscal 2005.
From fiscal 2000 through fiscal 2005, consumer-segment revenues increased at a 23% compound annual growth rate (CAGR), driven by a rapidly expanding level of Internet orders. However, over the past three years, despite improved operating efficiencies, operating margins in the segment remained relatively flat (between 5% and 6%), due primarily to increased advertising rates related to Internet services.
In the florist segment, revenues increased only at a CAGR of 1.5% from fiscal 2000 to fiscal 2005. However, operating margins improved over the past three years, due to increased operating efficiencies and lower levels of depreciation.
The company estimates that retail florist industry sales total approximately $4 billion annually. Of this total, floral direct marketers, including FTD's consumer segment, account for approximately $1 billion in sales. However, with the proliferation of Internet usage, this category has grown considerably over the past decade. At FTD, consumer-segment orders have grown at a 31% CAGR over this period, and Internet orders now account for nearly 90% of all orders.
While the floral services industry is highly fragmented, FTD itself believes there are two principal competitors to its consumer segment; 1-800 FLOWERS.COM (FLWS: hold; $7), which had revenues of $670 million in its fiscal year ended June 30, 2005, and Pro Flowers, owned by Provide Commerce (revenues of $177 million in its fiscal year ended June 30, 2005). FTD's principal competitor in the florist segment is Teleflora LLC, although in the past several years 1-800-FLOWERS.COM has aggressively entered this market.
FTD believes it can grow its consumer segment by more than 10% annually by continuing to direct consumers to the Internet for their floral and specialty gift purchases and by pursuing growth in additional specialty gift categories. It also plans to expand its lower-priced floral offerings to attract younger, less-affluent customers.
ECONOMIES OF SCALE.
The company believes it can grow its florist business at a rate in the mid-single digits by expanding its product and service offerings and increasing penetration of the industry through simplified pricing and improved sales and service capabilities. FTD is also pursuing opportunities to expand its presence in the supermarket and mass-market channels, which historically have not represented a meaningful portion of florist-segment revenues.
FTD currently expenses stock option grants. The company's defined-benefit pension plan and post-retirement health-care benefits were frozen in 1997. Existing pension liabilities are so low as to be considered immaterial. As a result, Standard & Poor's Core Earnings estimates are expected to track reported GAAP (generally accepted accounting principles) results.
Our earning per share (EPS) estimate for the fiscal year ending in June 2006 is 76 cents. The estimate is based on expected consumer segment revenue growth of 8.4%, a decline in florist-segment revenue of 2.0%, reduced debt levels, and share repurchases. We project fiscal 2007 EPS of 87 cents, reflecting 7% revenue growth in the consumer segment and increasing economies of scale in the florist segment.
STRONG FREE CASH FLOW.
The shares recently traded at 14 times our calendar 2006 EPS estimate of 81 cents, a significant discount to the S&P SmallCap 600. We believe the shares are a compelling investment at this valuation given FTD's quickly growing Internet-based consumer segment, its stable and highly profitable base in its florist segment, and its strong brand-name recognition.
While we expect customer-order growth in FTD's consumer segment to slow from the lofty levels of the past several years, we believe order growth of 5% to 6% annually over the next several years is attainable. However, we do not expect operating margins to expand meaningfully due to intense industry competition. We do not expect the florist segment's strong operating margin to erode, despite increasing competition, as the Internet's increasing share of market orders should ensure continued network demand among florists.
Additionally, we are impressed with the company's strong free cash flow generation. From fiscal years 2003 to 2005, capital expenditures at FTD averaged only $5.3 million dollars per year, well below its average earnings before interest, taxes, depreciation, and amortization (EBITDA) of $36.8 million. We do not expect the company's capital-expenditure requirements to increase meaningfully over the next several years.
INSIDER MAJORITY STAKE.
Also, since the company does not own or operate any retail operations and therefore does not bear the burden of maintaining physical inventory or the costs of warehousing and distribution facilities, working capital requirements are minimal. We think cash flow from operations will remain considerably in excess of capital expenditure requirements in the future, allowing FTD to reduce debt and repurchase shares.
Our 12-month target price of $15 is based on our discounted cash flow model, which assumes revenue growth of 4% to 5% annually over the next several years, with gradually declining rates thereafter, a weighted average cost of equity of 12%, and a terminal growth rate of 2.8%.
Investors should be aware that, as of Aug. 31, 2005, the company's directors and executive officers, as a group, owned a majority (54.8% of outstanding shares) stake in the company.
Risks to our investment recommendation and target price include the potential for a major economic downturn that could negatively affect consumer segment revenue, and the possibility of a significant increase in Internet advertising costs or competitive pressures that significantly slow revenue growth or narrow operating margins.