Description

Investment Thesis

The absurd valuations received by companies that are perceived as safe and recession-resistant has been thoroughly discussed on this board (see my short WDFC face-ripping from early 2017). I’m taking a different tack here and assuming businesses of equal quality exist at reasonable valuations. While not sexy, such investments could be favored over the opportunity set that value investors have been forced into this market cycle, which has essentially consisted of shorting insane valuations and dumpster diving.

I believe Amdocs fits the bill. The firm is the world’s leading provider of billing and customer care (BSS) and operations support systems (OSS) to communications service providers. The firm offers a broad range of services, such as helping customers add premium channels to their cable packages, send text notifications to wireless users about to exceed data limits, and working with telecom providers to enhance their infrastructures. Around 75% of revenues are recurring and driven by long-term contracts or ongoing maintenance and support. Switching costs for customers are high. This results in a stable margin and free cash flow profile.

Amdocs’ shares were pressured earlier in the year due to several issues that appear transitory. Revenue from its largest customer, AT&T, were weak due to the merger with Time Warner. This is unsurprising and should stabilize. Free cash flow has also been relatively weak due to higher working capital related to certain projects, but this is expected to normalize. Lastly, Spruce Point put out a lengthy short report on the company, but I believe many of the issues called out are unfounded. Amdocs is a high-quality business trading at a reasonable valuation. The company has no debt, $472mm in cash and a $9.3 billion market cap. The free cash flow multiple is ~15.5x based on $575mm in normalized FCFF, significantly below multiples being assigned to other high-quality, recession-resistant businesses. Further, I expect reasonable long-term revenue growth to compound earnings over time.

Business Description

The Company operates with one reporting segment but provides services in two distinct areas. BSS, or business support systems, are used by communications providers for customer-facing activities such as accepting orders, processing payments, managing products, and handling customer inquiries. OSS, or operations support systems, are the nuts and bolts enabling telcos to manage their networks and involve tasks such as network inventory, service provisioning, network configuration, and fault management.

Amdocs describes its business in the following way:

Our offerings enable service providers to efficiently and cost-effectively introduce new products and services, process orders, monetize data and content, support new business models and generally enhance their understanding of their customers…

We believe the demand for our solutions is driven by our clients continued transformation into digital service providers to provide wireless access services, content and applications (apps) on any device through digital and non-digital channels. It is also driven by the trend towards integrated service offerings which we believe is leading to increased merger and acquisition activity among our customers who then require systems consolidation, which we provide, to ensure a consistent customer experience at all touchpoints.

Telecom’s outsource non-core operations to Amdocs. The company typically provides software licenses with significant customization and integration. Approximately half of revenues are derived from long-term managed services agreements where the company manages the data center operations, IT infrastructure, and business processes for billing and customer care. It’s important to note that Amdocs does not operate call centers like some of its peers. An additional 25% of revenue is recurring and is driven by maintenance and support that does not fall under long-term agreements. Lastly, 25% of revenues are project-based, which can be variable and difficult to predict. Recently, this revenue stream has been driven by complete overhauls of customers’ systems. Amdocs’ reputation in this circle is strong, and it is occasionally enlisted to take over a competitor’s failed implementation.

Amdocs provides service to most of the world’s largest telecom and media companies, including AT&T, Verizon, Comcast, Netflix, Vodafone, Telefonica, and Singtel. Customer concentration is therefore somewhat significant. AT&T represents roughly 25% of sales, but no other customer is more than 10% However, Amdocs is the clear leader in the space. For what it’s worth, the company has repeatedly been classified as a leader in Gartner’s annual Magic Quadrants reports. Most competitors cannot service the largest customers. For example, competitor CSG Systems services Comcast with legacy systems, but is highly unlikely to be able to poach the AT&T business from Amdocs because CSG’s platform cannot service wireless customers with millions of subscribers. Further, the telecom industry is shifting toward software-defined networking (SDN)/network functions virtualization (NFV), which means software functions are replacing less flexible hardware solutions. Amdocs is on the cutting edge of virtualization through its early work with AT&T, which is virtualizing large parts of its network. Amdocs is using this experience to help other providers transition their networks toward software-based solutions, which could be a meaningful growth opportunity.

Financials

Amdocs is a stable slow grower. Revenue has consistently grown revenues by 2-7% annual over the last decade. In 2009, sales dipped less than 10%. It’s worth noting that legacy business has been consistently declining by double-digits annually, but only represented $45mm of the $3.975 billion in revenue last year and will therefore be less of a headwind going forward. Margins have been remarkably stable, varying by less than 140 bps from peak to trough. EBITA was $622mm in 2018, up from $473mm a decade earlier.

In 2018, spending by AT&T dropped 16% due to the Time Warner merger. This is not uncommon after mergers. Spending has historically declined after AT&T’s large acquisitions, but then increased as the target is integrated. Excluding AT&T, revenue increased 12% in 2018, resulting in 2.8% overall growth. M&A was a tailwind and was offset by FX, so organic revenue growth was probably around 1.5%.

The company is incorporated in the Island of Guernsey, and therefore receives favorable tax treatment. Last year, the firm’s tax rate was 15.9%. Guernsey is being pressured to revamp its tax system, and there could be a risk that Amdocs can’t meet the requirements. Even so, the firm generates most of its profits in the U.S., so the loss of favorable tax status is unlikely to have a dramatic impact.

The balance sheet is clean with no debt and $472mm in cash. However, this is the lowest cash level in years as the firm is building a new headquarters than management claims will be accretive over time due to rent savings. Free cash flow has declined over the last three years from a peak of $652mm in 2015 to $326mm in 2018. This is partly due to spending on the new HQ but is also related to significant cash outflows to fund working capital. Management claims that an increase in large transformation projects is the culprit, which should normalize. DSOs have risen from 72 days in 2015 to 89 days last year. If one were to assume that an incremental 15% of revenue ($590mm) is derived from transformation projects, this would imply that it takes 6 months to collect compared to 72 days for the rest of the business, which seems plausible. Management predicted a dramatic improvement in normalized free cash flow in 2019, up to $600 excluding a $50mm legal settlement and the new HQ, which would indicate the working capital build is slowing.

Spruce Point Short Report

In January 2019, notable short seller Spruce Point released an extensive short report on Amdocs. A link to the summary and downloadable report is provided here. https://www.sprucepointcap.com/amdocs-ltd/

Spruce Point isn’t completely off base. I accept that Amdocs is low-growth business and cash flows have been poor in recent years. However, many of the more specific accusations don’t hold water.

1)      Question financials and accounting

·       Spruce Point points to the stability of Amdocs’ margins compared to CSG and AT&T. In fact, CSG’s margin a quite steady as well absent declines around contract renegotiation, but Amdocs does not have the same contract risk as CSG. Additionally, comparing Amdocs’ margins to AT&T is ridiculous. The two don’t operate in the same industry. AT&T’s markets are highly competitive and capital intensive, while Amdocs is a software and services provider.

·       The growing gap between GAAP and non-GAAP EPS is due to M&A that comes with significant amortizable intangibles.

·       The one-off tax benefits that Spruce Point thinks are suspect are typically expirations of statutes of limitations related to unrecognized tax benefits, which are likely to repeat. Further, the tax rate has been stable for years. It does not appear that Amdocs is engineering one-off tax benefits.

·       The 20F is signed off on by the Secretary and Head of IR, which Spruce Point claims is done to shield executives from liability. However, both the CEO and CFO sign Certifications attached to the 20-F that state there is no fraud.

2)      Use of M&A to obfuscate negative organic growth

·       Spruce Points highlights the lack of organic growth disclosure and concludes organic growth is actually negative based on its estimates of acquired revenue. It points to EV/sales multiples around 0.5x despite the purchases being high-tech.

·       One example it notes is Vindicia, which it claims earned over $90mm in annual revenue, while management guidance was $20-$25mm.

·       The source provided for the $90mm figure appears to have been misread. It states Vindicia generated over $90mm in revenue for clients. “Vindicia provides enterprise-class subscription billing solutions that keep consumers connected to the services they love, and businesses connected to the subscription revenue they need. Vindicia has processed over $21 billion and generates over $90 million in annual revenue for clients like TransUnion, IAC, Vimeo, and Next Issue Media.”

·       For the 2018 acquisition of Vubiquity, which management noted would add $100mm in annual revenues, Spruce Point used $250mm of acquired revenue based on a source from 2014. An industry blogger noted the following, “Some caution is appropriate in concluding revenue has meaningfully decreased, since Vubiquity’s business model may have passed thru content licensing revenue. Such mechanisms or accounting treatment could result in materially different statements on revenue, depending on the context of the statement.” http://blog.devoncroft.com/2018/02/01/media-service-provider-vubiquity-acquired-by-amdocs/  

·       It is likely that Spruce Point has drastically overestimate the revenue contribution of other recent purchases. It is grasping for straws to make this point. In reality, a fiar estimate is approximately half of Amdocs total revenue growth has come from M&A since 2014.

3)      Non-transparent PP&E accounting used to boost FCF generation.

·       Spruce Point claims the significant increase in European assets points to accounting manipulation. While it’s true that there is an imbalance between the physical location of assets and where the company generates revenues, this could be explained by Amdocs transferring its internal use software to Cyprus to receive favorable tax treatment.

·       Spruce Point states Amdocs doesn’t capitalize internal use software costs like peers. In fact, the company follows the same practice. It is clearly noted in the 20-F footnotes. One could argue the unamortized balance growth in recent years is a red flag, but the net carrying amount as a % of revenue isn’t much different than peers.

·       Regarding the new HQ, Spruce Point claims it cannot reconcile the company’s spending. This is because it isn’t comparing apples to oranges. In some cases management discusses a gross figure, while other a figure net of the JV investment.

4)      Questionable financing behavior

·       Factoring receivables as a sign of financial strain: Spruce Point’s own estimate of factored receivables is just $36mm. This hardly seems material for a company with no debt and $500mm in cash.

5)      Board entrenchment and management incentives

·       E&Y has been the firm’s auditor since its IPO, which apparently is a negative to Spruce Point. Plenty of investors view changing auditors as a red flag.

·       Spruce Point cherry-picked negative employee reviews on Glassdoor. The overall rating with more than 4,000 reviews is 3.5 stars, in line with many large corporations.

·       Spruce Point claims DOX is granting in-the-money options. They note that the fair value per option is increasing with all other disclosed inputs remaining the same. It seems that there is fundamental misunderstanding of Black-Scholes. The increasing value of Amdocs’ stock price results in a higher fair value, as do higher risk-free rates.

6)      Valuation

·       Spruce Point values Amdocs at the same EV/sales multiple as call center operators like Sykes and TTEC, which have half the margins DOX has and don’t spend nearly the same on R&D.

Q419 Results

Amdocs reported Q419 results as I was writing this report. Sales were up 3.6% on a constant currency basis, and margins improved 120 basis points due to higher gross margins, SG&A leverage, and slightly lower R&D. DOX beat its normalized free cash flow of $600mm by $13mm. Actual free cash flow was $528mm. As expected, revenues from AT&T were down significantly (-12%), but this was offset by growth elsewhere. Amdocs announced a multi-year extension of its contract with AT&T. This removes a primary risk to investors. However, this will also lead to significantly lower FCF generation in 2020 of $480mm (ex-HQ spending). Management pointed to upfront investment in setup and training due to the renewal, in addition to deferred invoicing milestones. Spruce Point could use this to publicly poke Amdocs again.

Valuation

I’m valuing DOX assuming $4.2 billion in revenue next year (up from $4.09bb), 16.4% EBITA margin, a 15% tax rate, and a 12x invested capital turnover ratio. A 3% growth rate and FCF multiple of 20x results in a valuation of $88/share, or ~30% upside to the current price.

Catalyst

- Stabilization of AT&T revenue

- Reversal of working capital trends