Description

Attention VIC shoppers: BCE Emergis (IFM - TSX) is on sale now. $3.10 gets you about $2.50 in net cash and securities, plus a business worth another $3 to $5. This is a turnaround situation in which a new management team & board have done a very good job thus far righting the ship. The new Chairman just bought $9.5M worth of stock, and numerous other insiders have loaded up as well. Plus, two reputable value investors with a history of activism have just bought a combined 23.4% of the shares. One of them – Crescendo Partners – has taken a seat on the board. Emergis recently paid a $1.45 special dividend and I would not be surprised if they paid another within a year. I would also not be surprised if this company eventually got sold.

All figures in Canadian $.

BCE Emergis supplies eBusiness solutions to the North American financial services and Canadian health care industries. Bell Canada Enterprises (BCE) invested in them as part of its bubble-era diworsification program back in 1998. But in a story that is all too familiar, diversification did not work out well for this incumbent telco and a chastened BCE is now divesting non-core assets. Their 64% stake in Emergis was sold via underwriting syndicate in June at a dividend-adjusted $3.95 per share, and the sale apparently spooked the market and accounts for the first leg down you see on the price chart (the second leg simply reflects the dividend).

These fears are overdone. First off, I highly doubt BCE sold because they know something we don’t. They’d have to disclose it in the offering docs, first of all. Also, big, lumbering low-growth businesses like BCE are rarely good buyers or sellers of assets. They sold their yellow pages business a few years back for a song to a group led by KKR which converted it to an income trust and flipped shortly thereafter for a huge profit. BCE is under pressure to refocus and Emergis is a rounding-error that has required much more attention than makes sense for anyone running a 19B revenue business.

Secondly, Emergis should do just fine without BCE. BCE hasn’t put any new money into them in years, and frankly they don’t need money because they’re FCF positive and have about $240M in the bank. The BCE name has probably been helpful in closing big deals in the past, but this company has basically left the nest already and has plenty of blue-chip customers/partners who are happy with them. And get this – 84% of revenues are recurring, so they don’t have to win a ton of new business to show growth. Two projects (w/ Freddie Mac and Visa) could start to generate meaningful revenues toward late 04/2005.

But it’s not just the BCE thing that has been weighing on the stock. Divestitures and a major contract expiry have lowered revenues and obscured the progress they’ve made in improving margins at the remaining units, leading some to believe that the remaining Emergis is a collection of dying businesses. That’s just not true – this company is growing, margins are improving, and it’s just starting to throw off cash – but you’ve got to peel back the onion a bit to realize it.

Finally, some of the selling pressure could be simply due to the fact that this recently dropped below $5, meaning some folks can’t own it anymore. To borrow a phrase from Zeke375, some of this might be the standard ‘$5 to $3’ swoon.

Emergis has two businesses: eHealth and eFinance. eHealth addresses the Canadian health market by enabling web-based processing of claims for insurance companies and workers’ compensation boards and provides related security services. Its network reaches 99% of all pharmacies and 65% of all dentist offices in Canada. Revenues were 56.2M in 03 and should be 72.1M in 04. 98% of these are recurring. Since Emergis overhauled its management team about a year and a half ago, they’ve brought EBITDA margins from negative territory in 02 to 18% as of last quarter. So, it’s a nice business to be in.

eFinance is a bit more troubled, but the problems are being fixed. It’s a collection of e-business that automate finance-related processes, some of which are growing, some of which are not. This includes eInvoicing, point-of-sale transaction processing, business-to-business e-payments, web-based tax filing for businesses, etc. Revenues appear to have bottomed and should show a little growth in the second half. EBITDA margins just turned positive. As I mentioned, two major projects with Freddie Mac and Visa should start to gain traction in the next few quarters. Hard to say what the upside is on those but they’re definitely a plus.

Emergis recently made some tiny acquisitions to bolster its eFinance offerings, and they appear to be working out. They make more, which I expect to also be small. They’ll probably also sell some of the non-growing units, so in terms of cash usage I think of it as a wash. I think any cash spent on acquisitions will likely have a quick payback due to the investors I mentioned above.

The contract I referred to is dubbed the Bell Canada Legacy contract – a large, profitable piece of business with BCE that just went away. I won’t dwell on it because it’s no longer a factor. I haven’t included it in any of the figures you’ll see in this writeup.

So what you’re left with is a company with run-rate sales and EBITDA margins of about 200M and 10%, respectively. I think they’ll achieve a 15% EBITDA margin simply by finishing the restructuring program. No Herculean feats required. For what it’s worth, Eric Rosenfeld (the head honcho over at Crescendo) was on ROB TV (the Canadian CNBC) shortly after taking his position and expressed a similar view on margins.

Backing out the net cash of 240M and about 16M of securities (options related to another public company which they got as part of a past acquisition), I get an EV of about 63M. With 15% margins, EBITDA will be over 30M. So, EV/EBITDA is a paltry 2X. EV/sales is 0.4. Meanwhile, publicly traded comps average around 13X EV/EBITDA and 2.3X EV/sales. Private market transactions seem to be in the neighborhood of 2-3X sales.
Even if you penalized them for the turnaround nature of this story, you could still drive a truck through that spread.

Let’s say you put a 10X EV/EBITDA multiple on Emergis. Relative values aside, would that make sense on an absolute basis? Yes – EBITDA is growing rapidly due to top line growth in eHealth and due to the fact that margins are at an inflection point at eFinance (and going in the right direction). Importantly, a big % of EBITDA turns into FCF because capex is far below D&A and because this company has tax assets that will shield almost all of its pretax income for a long, long time. Specifically, they’ll be able to shield over 250M of pretax income.

A 10X multiple on EBITDA of 30M gets you $300M for the core business, or close to $3/share with 103M shares out. Alternatively, a 2.3X EV/sales multiple on 200M sale plus a smidgen of growth gets you close to $5/share. Add that to the $2.50 of net cash and securities and you’re looking at a $5.50 to $7.00 stock price.

Regarding those two investors, Crescendo bought 13.4% of the shares at an average cost of about $3.40 after backing out the dividend. Though they’re based in NYC, Crescendo has a history of taking an active role in Canadian companies and seems to surface value most of the time. They were the catalyst at another Canadian public company - Spar Aerospace - which was sold to L-3 Communications in 2001, for a gain of around 150% in 2 years. With their foot in the door at Emergis, I wouldn't be surprised to see another significant dividend, or perhaps a buyback if prices stay at this level. A good chunk of cash is tied up due to reps & warranties related to a recent divestiture, but this requirement goes away around Feb ’05.

The other large investor (10%) is Letko, Brosseau & Associates. I confess to not be familiar with them, but my Canadian buddies tell me they are a “very good value manager” based out of Montreal. Here’s one heartwarming tale:

“I met them when I owned Ford Canada, they were the driving force behind pushing for a higher value for the take out of the minority shares. They both came from CN pension. They are very good thinkers, and have great integrity. I bailed from the stock prior to the litigation, they held and fought the case through to completion.”

To sum up, given the investors, insider ownership, and management track record, it’s safe to say this company is batting on your team. I think you’re looking at a potential double or better, with downside limited by the huge net cash position. I’ll take those odds all day long.

I’m not affiliated with anyone mentioned in this report.

While I’m not adamant about it, I would recommend that U.S. investors not hedge the currency if they buy this. I am wary of the U.S. Dollar for all the reasons that WEB cites, and I view the Canadian Dollar as a “less bad” currency. As they say, if you choose not to decide, you’ve still made a choice, and I’d rather not choose the Buck over the Loonie at the moment.

www.emergis.com

Comps used:
EPAY
FDC
CKFR
DGIN
CORI
FISV
NDC
ESRX
TZIX
HTLH

Catalyst

strong growth in EBITDA
sale of weaker eFinance businesses
potential 2nd special dividend as early as Feb '05 or buyback
potential sale of entire company