Following on from a recent blog post on what makes a great short, we will discuss the Thematics / Structural Declines component of the Montaka short framework, using a real-life example.
As a quick recap, structural declines refer to changes in industries which are non-cyclical in nature and typically occur over long periods of time. The changes to that industry, usually a result of fundamental shifts in the competitive landscape, are unlikely to reverse and can create an inexorable headwind for companies. Oft-cited examples of declining industries include newspapers being displaced by online news sources, or film cameras being displaced by digital cameras. Another interesting example of an industry in unmistakable structural decline is the physical mail industry.
Physical mail volumes in the U.S. have been declining for some time. Consider that total mail volumes for the United States Postal Service over the last decade have declined at a 3.5% annual rate.
This decline is being driven primarily by: 1) the rising use of emails for correspondence; 2) increasing levels of online advertising causing declines in advertising mail volumes; and 3) firms seeking cost savings by reducing physical mail output and driving paperless adoption of statements. For example, J.P. Morgan in its 2016 investor day commented that it was actively driving the electronic delivery of statements, given that paper statement deliver costs c.$0.50 compared to just a cost of just $0.01 for electronic statement delivery. This sentiment is echoed amongst high-volume mailers such as financial institutions and law firms – they all recognize reducing physical mail output as a tangible opportunity to reduce costs. This has an impact on firms in the mail postage meter market such as Pitney Bowes (NYSE: PBI).
PBI sells machines which enable clients to generate mail. Take the example of a law firm that must send mail to clients on a regular basis. Pitney Bowes’ machines will typically print the required document, fold it, insert it into an envelope, and then stamp it. By purchasing a Pitney Bowes machine, the firm can avoid the arduous and costly process of manually folding each document into an envelope and putting on the postage stamp. There is a genuine usage case for these mail postage meter machines. However, the backdrop of a persistent decline in U.S. mail volumes is creating difficulties for PBI.
Customers are buying less of PBI’s mail equipment, with equipment sales falling 10% YoY in FY15. Further declines are unlikely to be stymied by introducing new equipment with improved features. Through talking to industry experts, the Montaka team has learned that the mail postage meter industry has reached “peak innovation”; customers are satisfied with what the current generation of machines do and have no desire to upgrade to machines with more features. In other words, the mail postage meter market is driven by replacement demand.
PBI’s 2015 annual report, when discussing the reason for declining equipment sales, noted the “continuing trend of clients to extend existing leases rather than purchase new equipment”. Despite this trend of client preferences for lease renewals, rental revenues declined 9% in FY15 due to a lower installed base of mail postage meters and clients shifting to cheaper, less-featured machines. As mail volumes decline over time the aggregate number of PBI’s machines required by firms also falls which hurts future demand.
There are further flow-on effects from the industry decline that hurt PBI’s business. Lower equipment sales and a smaller lease portfolio have caused a prolonged decline in PBI’s financing revenue. Furthermore, declining mail volumes also have a negative impact on the sale of supplies such as ink. It is evident that the industry-level deterioration has affected PBI in a number of nuanced ways, all of which are bad.
The structural decline element of the Montaka short framework seeks to identify these industry-level changes and select companies that have a very low probability of escaping the pernicious effects of these changes. In a world where the word disruption has infiltrated the common lexicon when discussing businesses, the ability to seek out businesses in structural decline and profit from their decay serves as another tool to generate outperformance for clients, in addition to the high quality businesses the Montaka team selects for inclusion in the long portfolio.
Montaka is short the shares of Pitney Bowes (NYSE: PBI)
George Hadjia is a Research Analyst with Montgomery Global Investment Management. To learn more about Montaka, please call +612 7202 0100.