Description

Alight – Investment Thesis

June 2024

All figures presented in US$ millions, except for per share data

All price data as of 6/24/24

Situation Overview:

Alight Solutions (“ALIT” or the “Company”) is a human capital management ("HCM") provider to large enterprises focused on employee wellbeing, namely health, wealth, and leave benefits. The Company offers a variety of solutions including benefits administration, healthcare navigation, financial wellbeing, and leave of absence management to 35m+ employee participants across ~5k clients, including 70% of the Fortune 100 and 50% of the Fortune 500 ⁱ.

In March 2024, ALIT announced the sale of its less recurring, lower margin Professional Services and Payroll Outsourcing segments (representing ~30% of revenue and ~20% of EBITDA) to H.I.G. Capital for ~$1.2bn (~10x EBITDA and ~24x FCF), transforming the Company into a pureplay benefits administration player. Following divestiture close (expected at the end of Q2 FY24E), sale proceeds are to be used to deleverage the Company to ~3x net leverage and to buy back shares ⁱⁱ.

The remaining ALIT business (the “RemainCo”) will immediately see recurring revenue expand from 84% to 93% of total revenue and EBITDA margins expand by 300bps to ~25%. In addition, ~$20m in dis-synergies (i.e. temporary stranded costs) are expected to be managed out of the RemainCo within one-year post-close and $75m in run-rate savings are expected to be achieved through FY25E through on-going back-office restructuring initiatives. Over the medium-term, the Company expects the RemainCo to generate 4% to 6% annual revenue growth and grow EBITDA margins a further 300bps to ~28% ⁱⁱⁱ.

Despite a market leading position in a mission-critical industry, increasingly recurring revenue streams supported by a loyal, diversified customer base, and cash-generative operations with opportunities for further revenue and margin expansion, the market does not appear to be giving ALIT credit for its recent transformation initiatives, in part due to a ~3% revenue decline YoY for the RemainCo on a comparable basis in Q1 FY24 following weak H1 FY23 bookings driven by timing (given lumpiness associated with large wins). The Company is expected to return to growth in H2 FY24E ^iv.

We believe ALIT should trade at 10x normalized PF EBITDA, implying an upside of ~25% in a base case scenario. We expect this discount to close as the Company provides formal FY24E guidance for the RemainCo after divestiture close and hosts an investor day (expected prior to year-end).

While not underwritten in our base case, we believe the Company could be an attractive take-out candidate in the future as a pureplay benefits administration player. Additionally, the presence of activist investor Starboard (owners of ~7% of outstanding common stock; recently granted two board seats) helps de-risk the investment case.

We recommend ALIT as a long with a target price of $9.31 (~24% upside).

Historical Financial Data ^v:

Valuation:

We believe a business with the RemainCo’s financial profile and quality should trade at least at 10.0x PF normalized EBITDA. For reference, this compares to Voya Financial’s acquisition of Benefitfocus (a health benefits administration competitor) in January 2023 for an estimated ~11.5x trailing EBITDA. Another comparison point is H.I.G. Capital’s acquisition of ALIT’s less recurring, lower margin Professional Services and Payroll Outsourcing segments, which were sold for ~10x EBITDA.

At this target multiple, we believe ALIT has upside of ~25%, equating to an implied normalized FCF yield at the target price of ~5.3%. Our base case assumes the Company utilizes sale proceeds to deleverage to ~3x net leverage, with remaining proceeds used to repurchase shares.

Below is our valuation build. We present three scenarios: A consolidated current build of the Company (pre-divestiture), a PF build of the RemainCo, and a PF build of the RemainCo assuming the aforementioned share buyback.

Our principal assumptions include:

1. Normalized EBITDA and FCF: PF normalized EBITDA calculated as FY23 adjusted EBITDA plus $20m in temporary dis-synergies (expected to be managed out of the RemainCo within one-year post-close) and $75m in run-rate savings (expected to be achieved through FY25E through on-going back-office restructuring initiatives). PF normalized FCF calculated based on management’s midpoint operating cash flow (“OCF”) conversion target for FY24E (55-65%) and capex held in line with FY23 (management indicated FY24E capex would be ‘elevated’; This estimate represents a ~7% PF capex margin vs. a medium-term target of 4-5%) ^vi

2. Divestiture Proceeds: Valuation assumes 25% immediate tax leakage for divestiture proceeds per management guidance (majority of which is not expected to be paid until FY26E; ~$300m tax leakage total ^vii). Valuation fully recognizes $150m in net seller notes ($200m gross) as cash for net debt/leverage purposes (not expected to be paid until FY26E; $150m worth of gross seller notes are contingent on divested segment performance in FY25E ^viii)

3. Share Buyback: Valuation assumes the Company is able to repurchase ~58m shares at today’s current share price of $7.54 to achieve 3.0x net leverage. This represents a cash outflow for share buybacks of ~$440m (compares to current share buyback authorization of ~$250m)

Our analysis does not give the Company any credit for potential revenue expansion (as business-process-as-a-service (“BPaaS”) offerings continue to grow), further margin expansion opportunities (operating leverage/efficiencies), or ongoing OCF conversion growth, which could drive multiple expansion.

Investment Thesis:

1. Market leading player in a fragmented, mission-critical industry

The benefits administration industry is highly fragmented, with individual vendors typically focused on specific point solutions. ALIT estimates that the average Fortune 500 company utilizes 30-50 different point solutions for employee wellbeing and healthcare administration alone ^ix, driving high costs and poor employee engagement as a result of disjointed systems. This is a large component of total corporate spend – ALIT estimates a $73bn TAM (including the divested Professional Services and Payroll Outsourcing segments) ^x.

In contrast to competitors, ALIT offers a range of solutions including benefits administration, healthcare navigation, financial wellbeing, and leave of absence management through one integrated solution. Through Alight Worklife, the Company’s front-end platform, employees can view all their company benefits in one place.

Given the above and the Company’s 25-year operating history, ALIT is a market leader in the industry. According to NelsonHall, ALIT has the largest market share by revenue in the health and welfare administration services space and is the largest non-financial 401k record keeper by total assets. Additionally, Plansponsor indicates that the Company is one of the largest pension administration providers by total number of participants ^xi.

2. Sticky, highly visible recurring revenues supported by loyal, diversified customer base

ALIT’s revenues are highly sticky, with the RemainCo exhibiting 97% PF revenue retention and 93% PF annual recurring revenue. The Company typically provides its services under a 3-5yr contract structure, in which clients pay a fixed ‘per employee per month’ fee (which varies based on the number and type of solutions provided), typically structured with embedded inflation protection ^xii. The Company is in the process of implementing a new pricing model to separately bill its tech and services offerings, leading to better overall monetization ^xiii.

As a result of this structure, the Company has high revenue visibility. As of Q1 FY24, the RemainCo has revenue under contract (i.e. signed commitments and renewals) of $2.2bn in 2024, $1.6bn in 2025, and $1.1bn in 2026 ^xiv.

The company saw poor bookings in H1 FY23 driven by timing (given lumpiness associated with large wins), which drove comparable revenue down 3% YoY for the RemainCo in Q1 FY24 (typical 12-18 month bookings to revenue conversion). ALIT’s bookings subsequently improved, driving a back-loaded revenue profile in FY24E. Quarterly revenue under contract for FY23-FY24E can be seen below:

Source: ALIT – JPM TMT Conference (May 2024)

The Company’s has ~5k clients, including 70% of the Fortune 100 and 50% of the Fortune 500 ^xv, with the largest customer making up only 3% of revenue. ALIT’s customers are highly loyal, with an average customer tenure of 15yrs for the top 25 clients, and come from diversified end-markets – The majority of revenue comes from Consumer (21%), Financial (20%), and Energy and Resources (19%) companies ^xvi.

3. Attractive financial characteristics with revenue growth and margin expansion opportunities

In a normalized environment, ALIT is strongly cash generative. FY22 and FY23 FCF were $138m and $226m, respectively, implying ~4-6% FCF margins and ~20-30% FCF to EBITDA conversion.

Over the medium-term, the RemainCo is expected to generate 4% to 6% annual revenue growth, led by ALIT’s BPaaS offerings. BPaaS is a set of SKUs that utilize technology to leverage the Company’s vast amount of data to create personalized insights and experiences for end-employees, delivered through the Alight Worklife front-end platform. Prior to Alight Worklife, ALIT delivered its offerings through multiple customized, inefficient platforms.

BPaaS represents ~20% of the RemainCo’s revenue and is expected to continue growing strongly at ~15% annually vs. 2-4% for the non-BPaaS portion of the business ^xvii (average BPaaS deals are ~2.5x the size of non-BPaaS deals ^xviii). This follows a ~30% BPaaS revenue CAGR over the past three years, driving the Company’s overall revenue growth rate from low-single-digits to mid-single-digits ^xix. The Company could see continued annual revenue growth expansion as BPaaS becomes a larger portion of revenues.

In addition to 300bps of immediate margin expansion recognized following the divestiture of the Professional Services and Payroll Outsourcing segments, the Company believes it can drive an incremental 300bps of margin expansion to 28% EBITDA margins through FY26E. The main drivers of this are ongoing back-end restructuring activities (expected to generate $75m of RR cost savings through FY25E), operating leverage, and further cost initiatives (namely utilization of COEs and reduction in call center volumes) ^xx.

A bridge to the Company’s 28% EBITDA margin target can be seen below:

Source: ALIT – JPM TMT Conference (May 2024)

These factors, coupled with restructuring programs falling away and ongoing working capital initiatives, are expected to drive OCF conversion to 65-80% ^xxi (vs. ~40-50% achieved annually since FY19). We expect continued growth in total FCF as the Company drives revenue growth and operating margin expansion.

Risks:

1. Macroeconomic environment

The Company is exposed to economic slowdowns, which may impact customers’ financial health and HCM demand. In a recessionary environment, customers may opt to delay implementations as budgets shrink, driving lower non-recurring project revenue and impacting the timing of large deal go-lives in the future.

The Company is currently experiencing this dynamic following weak H1 FY23 bookings – On a comparable basis, overall revenue declined 3% YoY for the RemainCo in Q1 FY24, with project revenue down 11% YoY. The Company expects to return to growth in H2 FY24E ^xxii.

2. Competition

The industry is highly competitive. ALIT faces competition from smaller point solutions as well as larger enterprise solutions with substantial resources (Willis Towers Watson, Fidelity, etc.), with different competitors across each of its solution areas. Any market share loss to these competitors could slow top-line growth and impact margins.

Catalyst

• Formal FY24E guidance for the RemainCo after divestiture close (expected at the end of Q2 FY24E)
• Investor day (expected prior to year-end)