Description

Business Summary: BSG is a single source integrator of banking, investment and insurance outsourcing solutions. The intrinsic value of the business is roughly 50% higher than current levels on a DCF basis and the company has great opportunities for growth by cross-selling existing products and services to existing customers. They support over 20,000 financial institutions and corporate clients through three principal business groups:
1) Investment Services Group (52% of FY 02 revenue, 34% of operating income) provides fund services such as administration and accounting, transfer agency and shareholder services, compliance and legal support, and marketing and distribution services to a broad array of investment services including mutual funds, alternative investments and retirement plans. Competition is stiff in this market and concerns about declining equity values and mutual fund withdrawals have negatively impacted the stock price. BSG is somewhat differentiated from its competitors in that it provides a broader array of products and services than most of its competitors. While this segment represents more than half of the company’s revenue, it only produces 34% of the operating income since the margins in this business are note as good as their other businesses (17%).
2) Insurance and Education Services (25% of FY 02 revenue, 42% of operating income) The company is the leading independent distributor of life insurance and provider of the support services required to sell multiple lines of life related insurance and annuities. It distributes products of more than 200 of the most highly rated insurance companies through more than 100,000 insurance agents. They also offer more than 250 pre-licensing, continuing education and advanced designation courses. BSG was able to recognize several years ago that the policy underwriting, customer service and education and licensing operations of insurance companies are inefficient, paper intensive and in desperate need of streamlining. The company now supports agents with technology and infrastructure that allows them to underwrite a wide variety of policies while eliminating much of the paper and bureaucracy inherent in the process. BSG was the first mover in this business and has built a highly profitable, competitively advantaged business model. I am not aware of any established competitors in this business. There are other companies (like Fiserv) that provide claims processing to the insurance industry, but I do not think there are any other companies that provide a comparable breadth of services. The company brags in its 2002 annual report that they are 10 times larger than their nearest competitor. This business group is BSG’s most dynamic growth opportunity as they have by far the broadest range of services in a highly fragmented market. New market opportunities are quickly developing as more and more non-traditional entities (banks, CPA’s, attorneys, etc.) begin providing insurance. BSG has a huge competitive advantage in that they seem to be one of very few companies that are already ready to capitalize on the fundamental shift in the insurance industry’s distribution model. A non-traditional insurance provider who wants to be the “one stop shop” for financial products and services has to be able to provide a wide range of products and BSG has the capability to do this where their competitors can not. In addition, BSG already has relationships with the banks that are the primary “non-traditional” providers of insurance, a great opportunity for cross selling. Also the operating margins for this business are north of 40%!
3) Information Services (23% of FY 02 revenue) supports banks with information processing and imaging solutions, and insurance companies and corporate sponsored cash management programs with asset retention schedules. It is similar in this respect to Fiserv and InterCept Group. BSG’s enterprise wide banking platform supports 300 banks with integrated core deposit and lending, ATM and debit card processing, and internet banking. The company’s check imaging solution has been implemented by more than 1,150 organizations to convert paper based checks into digital or virtual checks and process them electronically. While they are probably the number 5 competitor in this business, they have been able to achieve scale and generate impressive operating margins (27%).


Discounted Cash Flow Valuation
In my DCF calculation, I have assumed that the company will maintain their historical EBITDA margins of roughly 27% and that the top line will grow at 12% for the next two years and then at 5% for the following three. I kept maintenance cap-ex constant at 40 million. I believe that growth of at least 12% is possible for a longer period of time, but the company will have to invest more than 40 million per year for that to happen. Assuming that any future acquisitions are “smart” capital allocation decisions (a possibly risky assumption I realize) it doesn’t significantly affect the valuation if you use a higher growth rate and a correspondingly higher cap-ex estimate. Using these assumptions, I calculate the present value of the next five years cash flows to be roughly $639 million. I then assumed perpetuity growth of 4% and a discount rate of 9% to imply a terminal value of $2.6 billion for a total enterprise value of $3,240 million. Subtracting net debt of $362.4 million I get a per share equity value of $24.00, a 50% premium to current levels.

Quick Summary
BSG is a company with some great competitive advantages and its value is roughly 50% higher than current market prices. In addition, the value of this business should continue to grow nicely over time as financial institutions of all types continue to look for ways to cut costs by outsourcing non-critical functions of their business. Scale in the outsourcing business is everything and BSG has managed to achieve it in several key areas. They have great opportunities for cross selling high margin business to existing customers which is almost always more profitable than getting new customers.

Risks
1) Sustained period of declining equity asset values (lower assets under management for mutual fund clients, etc.) will adversely affect the Investment Services Group.
2) Bad acquisitions. The company clearly has intentions to continue making acquisitions for growth.

Catalyst

1) “Good” acquisitions
2) Continued high growth in insurance business (and the other businesses too).
3) Valuation
4) Rebound in general equity values