By Gail Kailing July 29th, 2003 – Valassis Inc. (NYSE: VCI), provider of marketing services and Connective Media(TM), reported quarterly revenues of $243.1 million, up 20% from the second quarter of 2002. Second-quarter net earnings were $27.5 million, or $0.53 in earnings per share (EPS), including a refinancing charge incurred in May of $2.5 million net of tax related to the partial buy-back of the convertible debt issued in 2001. Editor’s Note: Alan Schultz, Valassis Chairman, President and CEO, is a man never at a loss for words, and in leading off this quarter’s earnings call, it was clear he was all smiles. The executive team led Valassis to its highest quarterly revenue in the company’s history, and is justifiably proud of it. Could this be another sign that the industry is beginning to turn around? Summary Topics - Quarterly Revenue Review - State of the co-op free-standing insert (FSI) business - Macro trends in spending for marketing and advertising - Balance Sheet Highlights - Q & A Quarterly Revenue Review Second quarter revenue increase of 20% year over year is the result of a "laundry list" of drivers: - The 42% increase in the cluster-targeted segment resulted from a broadening customer base. - Specialty retail expansion strategy drove a substantial portion of the revenue increase. - MaryAnn Rivers, new Vice President of Sales and Marketing, and her team had a great second quarter. - Valassis Relationship Marketing Systems (VRMS) frequent shopper database direct mail program saw a 61% increase in software sales. The VRMS is the best software tool available to manage frequent shopper data and has contributed to development of retailer relationships. - Valassis – the second and now the only company to offer a co-operative direct mail program based on frequent shopper data – has an open-ended opportunity. The company’s expanded product portfolio means that multiple products can be combined into a single client campaign – an integrated solution – that reaches the customer’s target audience in the most efficient and effective manner possible. Valassis’ integrated solutions are a unique capability that provides a substantial competitive advantage. To date the company has sold 11 integrated solutions to 10 different customers. Run of press (ROP) business is growing because of a strategy to offer multiple fee arrangements coupled with expansion of customer base. ROP revenue was up 100% over the second quarter of 2002. The NCH acquisition is off to an excellent start. NCH is a leader in terms of implementing controls, procedures, and policies designed to maximize redemption efficiency for manufacturers and retailers while assuring security and data integrity. NCH is developing the company’s international expansion plan for the entire product portfolio. Approximately half of the company’s revenue growth was from the NCH acquisition and half was organic growth. When considering that co-op FSI revenue was down 7.5%, this level of organic growth was substantial. In fact, non-co-op FSI revenue went from $63 million in the second quarter 2002 to $114 million for the quarter this year. The State of the Co-op FSI Business The co-op FSI industry unit base remained strong; page growth in the second quarter was in excess of 7%, similar to that of fit first quarter. This product is clearly a staple to the consumer packaged goods community. Valassis’ executive team continues to believe that the company’s co-op FSI market share will be 43% - 45% for calendar year 2003. The company was at the low end of the range for the first half of the year and is committed to regaining the share given up earlier this year. Valassis’ management believes that the industry works best in a "balanced" market share environment. Pricing continues to be intensely competitive. At this point over 80% of all 2004 pages to be covered by corporate contracts (that’s 85% of Valassis’ FSI business) have been negotiated. Valassis will continue to monitor the pricing environment looking for changes in competitive strategy, but to date has seen no change in pricing trends. When pricing does change, it is important to note that it will take time to work through current contracts. From an FSI cost perspective paper costs bottomed out in the second quarter of 2003. The super-calendared paper market has firmed up, however there is still sufficient supply. The prospect of the old Great Northern mill restarting super-calendared production should keep prices in check. Valassis has long-term contracts with collars that should protect the company from significant changes in the price of paper. Macro Trends in Spending for Marketing and Advertising It’s apparent there is growth in marketing budgets. Spending for broadcast media was up 2.8% in the first quarter and print was up 6.7%. Up front TV buys were strong for this fall. There has been a slight pick up in new product introduction activity related to Valassis’ sampling business. A recent Wall Street Journal article stated that Kraft would spend an additional $200 million in the second half of this year on promotion to improve their top line revenue growth. Kraft is just one example of a general trend to spend to grow the top line rather than cut costs to improve the bottom line. There continues to be a strong desire to link marketing spend to revenue generation; ROI continues to be a common theme. This attitude works in Valassis’ favor. That’s why a company like Kraft would allocate more of their incremental spending to promotion rather than general image advertising. The telemarketing "do not call" list should move $15+ billion to other direct response media vehicles starting in October of this year. Valassis believes clients should consider many of the products Valassis offers as part of this reallocation process. In summary, Valassis saw strong unit growth in businesses during the second quarter and these macro trends continue to look positive in terms of unit growth. Balance Sheet Highlights Cash on the balance sheet was $147 million. Approximately 50% of cash increase is a result of the new 1 5/8% convertible debt deal done in May. There is an increase in long-term debt of a similar amount. In the last five years the company has timed the debt market well. Based on what has happened with interest rates in just the last few weeks, it looks as if the most recent debt deal was also well timed. Q&A 1. Since Catalina has closed down its 1:1 Direct program, Valassis now has access to other potential retail clients. It was also a huge psychological win to get the Kroger business. Kroger is the largest US grocery retail chain. If you can do what Kroger needs from a loyalty-marketing standpoint - from a CRM standpoint - you can do it for anyone else in the retail grocery trade. It will open up significant doors for Valassis. The Kroger agreement is currently for loyalty marketing, but the company has been doing an increasing amount of business with Kroger beyond loyalty marketing, beyond direct mail. Kroger saw Valassis as an exceptionally strong partner when it came to at-home delivery of promotional material and viewed the company as an important partner who has a substantial number of products and services to help them accomplish their goals. It was competitive situation - Catalina had this contract or a contract similar to this and learned back in May that the contract was not going to be renewed with them and Kroger was looking in Valassis’ direction. Kroger did a complete analysis of Valassis’ capabilities and Catalina’s capabilities, Valassis’ strengths versus Catalina’s strengths, and made their decision. "We’re obviously honored that they selected us," stated Schultz. "We’re proud to be their partner." 2. All the international general managers have been trained in Valassis’ nine-step new business development process, which involves a number of things including consumer assessment, market assessment, retail trade assessment, etc. They have an initial indication of what products in the portfolio they think would work best and would be the ones they would like to start with. Valassis will be testing products in 2004 with European rollouts planned in 2005. While the company attempted to enter France a few years ago, that launch was pulled out. The plan for success this time is to have "in market" people on the ground that really know the market, the language, the culture, and have relationships with the customers. To try to develop new business in Europe from Lavonia Michigan is not a formula for success. With NCH there are a substantial number of people on the ground – ultimately they will be the difference. 3. From a paper standpoint, the company is projecting a mid- to high-single digit increase in the cost of paper over the next twelve months, however nothing particularly substantial is expected in the second half of this year. There is a lot of talk about the start up of the old Great Northern mill. Some speculate that it will start up in the fall, others that it will start in February. They have already started up other forms of production and have lowered prices in the market for those types of paper in order to start to build their "book" They are expected to do the same thing in the super-calendared arena. 4. Historically Valassis has gotten about 40% of revenue on International and 60% on US operations. In the second quarter, it was a 50/50 split. 5. Valassis is the greatest pricing pressure on anything print-related. There is still some industry overcapacity, however prices seem to have stabilized. They are not continuing to go down, but there has been no up-tick in pricing either. 6. There is some margin benefit when the company sells integrated services. There is really no one else offering a complete solution that can say, "here’s how to your reach all of your target audience and here’s the most efficient way of doing it with this combination of products." When presented that way, the client tends to look at the absolute cost to reach his target audience. They don’t concentrate on the pricing of individual elements. The focus tends to be more on questions like the following: "How are we targeting the message?" "How are we reaching the right audience?" "Do we have the right mix of products?" "What’s the effectiveness of each of the products?" "What type of response am I going to get from each product?" That’s one of the reasons we’re very encouraged about the integrated services. Valassis is concentrating on developing a repeatable sales process to accelerate the sales process and increase the number integrated solutions sold. 7. The foreign exchange rate has impacted NCH revenues positively. The exchange rate was a positive in Mexico from cost standpoint and in Europe from a revenue standpoint. 8. VMRS is relatively close to profitability now and should be profitable by the end of the year. 9. Catalina had a number of major retailers on their 1:1 programs and there are a number of opportunities. Winn Dixie, A&P, Albertsons – a through analysis of the top grocery retail clients has been done, and Valassis is in contact with all of them. 10. The company is also looking at a variety of new categories. Financial institutions, educational, real estate, insurance, wholesale, social services, even telecommunications are potential categories. Products for these categories include direct, polybags, solo inserts, and even co-op FSIs. For example, the credit card industry has gone from the equivalent of 10 national pages in 2001 to the equivalent of 22 national pages in 2002. And, in the first half of this year, the total is already at 21 national pages. There is anticipation of growth, it’s just a function of how much of the telemarketing reallocation will go to print. 11. Valassis anticipates a squeeze on margin as the mix of products changes. FSI is higher margin and revenue from other products will impact margins. The company has always focused more on absolute dollars rather than margins. More on earnings and cash flow. VRMS does have the characteristic of a co-operative program that allows Valassis to duplicate the margins of FSIs. 12. While Valassis has a lot of cash on hand, the company does like to maintain a strong balance sheet. It is hard to say whether there will be additional share repurchases the rest of the year. 13. While over 80% of all co-op FSI business covered by corporate contracts (averaging 27 months in length) has been negotiated, over 300 national equivalent pages are still up for negotiation. A single point of market share is equal to about 20-22 national equivalent pages, so it is difficult to project how the year will end. The timing is about the same as the last two years. In October the numbers will all come together for next year. About 15% of all Valassis’ business is bid, not contract. Those contracts are like media contracts in general, they deal with the business relationship – for example, % of spend – rather than a dollar value. 14. About $30 billion of related consumer marketing spend was in telemarketing, and Valassis anticipates that about half of that will shift to other vehicles. So far about 20 million households have signed up for the "do not call" list, and that’s still rising. There are 105 million households in US and if about 50 million households end up on the list, that’s about half the marketing spend that shifts to other media. 15. Valassis continues to monitor News Corps’ FSI business, and has not seen any measurable change in their approach. They continue to be aggressive and do not make it easy for the company to regain market share. If it is necessary and appropriate to secure business, Valassis will match their price. 16. Because Valassis has been able to offer category exclusivity, that has played a bit of a role in the market share realignment. News Corp had some clients unhappy that competitive products were run together. Category exclusivity is a contributor, but the ability to match price is a larger factor.