This Stock Should Not Trade at a Discount to Its Peer

Mark is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

If you do any form of reading or writing, you would have unwittingly come across many of the fonts trademarked by Monotype Imaging (NASDAQ: TYPE) such as Sans and Helvetica. Monotype Imaging boasts of moats in the form of trademarks and high customer switching costs and is currently trading at a 30% discount to its closest listed comparable Adobe (NASDAQ: ADBE) based on forward P/E, despite a higher ROA. It currently sports a meager forward P/E of 1.1%, with a goal of growing dividends backed by strong free cash flow generation.

Moats that matter

Shareholders of drug companies always fear the day that patents of blockbuster drugs expire, with nothing in the pipeline to fill the gap and prop up stock prices. Unlike patents, trademarks are perpetual in nature with no expiry date, offering investors a real sustainable moat over time. Monotype Imaging has trademarks on the key fonts in its font libraries, which are responsible for a significant amount of recurring revenues comprising a hybrid of per unit royalties and renewable term licensing fees. In addition, customer switching costs are high, as Monotype Imaging’s fonts are embedded in the hardware of electronic devices.

Misguided perceptions

The market perceives that Monotype Imaging’s OEM print imaging business will be adversely affected by the decline in the laser printer market. This ignores two key issues.

Firstly, the decline in the laser printer market does not affect all vendors equally. According to a 2012 Peripherals And Printer Markets report by ITCandor, Asian vendors such as Kyocera and Ricoh are gaining market share at the expense of the market leaders such as HP. These Asian vendors represented more than 80% of Monotype Imaging‘s printer imaging revenues, based on the company’s presentation at the 15th Annual Needham Growth Conference in January 2013. The gain in market share for Monotype Imaging‘s key customers will help to partially offset the negative effects of the sluggish growth in the laser printer market as a whole on its printer imaging revenues.

Secondly, while people associate Monotype Imaging with the print imaging business, Monotype Imaging has a diversified revenue base with only approximately 40% of its revenue derived from this business segment. Another key growth driver for Monotype Imaging is OEM display imaging which accounts for 25% of Monotype Imaging’s revenues. In April 2013, Monotype Imaging announced that it released a collection of typefaces designed for high quality e-reading experience, as part of various solutions that it is working on to optimize the use of text on digital displays. Management estimates that its current penetration for the display imaging market is less than 10%, compared with 30% for the printer imaging market, implying ample room for further growth.

Peer comparison

Monotype Imaging‘s peers include Adobe and Google (NASDAQ: GOOG).

Monotype Imaging’s relationship with Adobe is delicate, given that Adobe is both a customer and a competitor. As a customer, Adobe is not only a licensee of Monotype Imaging’s fonts, but drives a large amount of indirect business. The adoption of Monotype Imaging’s solutions in Adobe’s PostScript products is responsible for the sale of Monotype Imaging’s solutions to device manufacturers seeking compatibility with Adobe. As a competitor, cross-selling is a simple yet effective strategy for Adobe, as it has a wider product line than Monotype Imaging, in addition to a large user base.

Free is the new cheap in today’s world where consumers are taking freebies online as a given. Besides the hugely popular Google Drive, Google also provides open source fonts. I am overly worried about this, as I believe this will be similar to the situation in office productivity software where corporate users still use Microsoft Office, despite the proliferation of free open source alternatives such as Google Drive and Libre Office. Developers will rely on the scale and variety of Monotype Imaging‘s huge font library. Interestingly, according to a recent TechCrunch article, Google is making available its web fonts on the desktop for download, using Monotype Imaging’s SkyFonts utility.

Conclusion

Monotype Imaging is unjustified trading at a discount to its peer Adobe, given that it delivered a significantly higher ROA of 9.6%, compared with a ROA of 6.4% for Adobe. In addition to being more attractively valued, Monotype Imaging also provides investors with a small sweetener in the form of a 1.1% dividend yield. Monotype Imaging targets to pay out 25% of its cash flow from operations, and future dividends are expected to grow in line with revenue growth and margin expansion.

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Mark Lin has no position in any stocks mentioned. The Motley Fool recommends Adobe Systems and Google. The Motley Fool owns shares of Google. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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