Description

I believe Diebold Nixdorf (DBD) is a significantly mispriced business and perceived as a fast-melting ice cube, while in reality it is a critical technology partner to financial institutions and has a resilient business model with higher-margin services and software revenues making up the majority of gross profit pool. The market structure is more rational than 5 years ago, DBD has new products and software launches coming that can translate into market share gain. Meanwhile, mgmt’s DN Now Initiative is driving meaningful EBITDA improvement through cost efficiency programs and FCF improvement is coming shortly to demonstrate the relatively adequate quality of earnings. Upon execution, investors will pay a “real multiple” on EBITDA, EPS, and FCF (is 9-10x too much to ask?), resulting in the stock trading in the $30 to $35+ range in 2 to 3 years (2-2.5x MOIC) as the market appreciates the end market resilience and improving FCF conversion

Background / Company Description

DBD is a global leader in Connected Commerce with 75% of revenues from banking industry and 25% from retail industry. It acquired Wincor Nixdorf in 2016 for $1.8bn to expand its addressable market (mostly geographically),transform more aggressively towards the high-value services / software space, and capture cost synergies.

Banking industry: DBD has the largest ATM installed base globally with 31% market share (per RBR 2020 research). ATM industry is a duopoly to oligopoly in most local markets – DBD has 31% global mkt share and NCR is comparable at #2. DBD plays in over 100 countries across all regions and serves as a partner for almost all of the top 100 financial institutions worldwide.

Revenue make-up in the banking segment

• Products (35%): ATMs, cash recyclers, dispensers, etc

• Services (55%): maintenance and managed services

• Software (10%): most software applications are hardware agnostic and encompasses front-end applications for consumer connection points and back-end platform

Retail industry: DBD sells Electronic POS and Self Check Out terminals to retail chains with a major presence in EMEA (Nixdorf). It is a partner of a majority of top 25 global retailers, helping retailers with checkout automation, store lifecycle management and enhance consumer engagement / loyalty. It is a very low-growth business so I won’t emphasize much on it in this write-up.

Revenue make-up in the retail segment

• Products (43%): EPOS (Electronic POS) terminals, SCO (Self Check Out) terminals, and ordering kiosks for QSR

• Services (41%):  maintenance and availability services to optimize performance and total cost of ownership

• Software (16%): solutions covering click & collect, reserve & collect, in-store ordering and return-to-store processes 

In aggregate, 60%+ of revenues are from Services / Softwares, while ~90% of revenues are from its core regions (Americas and EMEA), as DBD exited meaningful amount of its APAC exposure over the years due to hyper-competitive nature of that region

Mis-perception 1: DBD is not as exposed to hardware as investors initially think

More than 70% of this company’s GP pool comes from recurring services and software revenues, providing stability. Product revenues make up only 28% of GP $ despite being 37% of total revenues due to lower margin. Global services contract renewal rate is > 95% historically. 60% of ATM installed base is under service contracts

DBD’s GM % improvement has been especially meaningful in services and software in both 2019 and 2020. Services GM % improved 260bps and Software GM % improved 1100bps+ (see below for drivers of improvement)

Mis-perception 2: cash is not dead (even after COVID)

Per Federal Reserve Study, while the number of ATM cash withdrawals has been declining LSD % in the US, value of withdrawals has been growing LSD % per year. For example:  average value of ATM cash withdrawal grew from $118 in 2012 to $146 in 2015 to $156 in 2018

Source: 2019 Federal Reserve Payment Study

The July 2020 Federal Reserve Cash Product Office study on cash usage demonstrates cash’s transactional use has decreased (as it does every year) but its role as a store of value has increased post COVID

The CPO asked 10 COVID-19 survey questions , which participants answered between May 2 and May 15, 2020. The questions focused on three general themes: cash holdings, changes in payment behavior, and cash avoidance. In general, participants reported holding more cash on their persons and especially as a store of value in their homes, compared to trends reported in the 2019 Diary

“2020 Diary” should read “2019 Diary” instead (typo in Federal Reserve study)

In fact, ATM installed base across top tier North American banks have been growing at a modest 0.7% CAGR over the past 5 years and flat over the past 10 years (ATM metrics aren’t disclosed by C/WFC/JPM)

Branch count has consistently declined at ~3% annual clip as banks shrink their retail footprints; ATMs per branch has been increasing as this is a way for banks to establish physical presence while reducing labor and real estate footprint. ATM with additional functionality has been critical to branch transformation

Stability is the name of the game (for now) – ATM demand is likely to be steady and resilient in the next 5 years. ATM installed base was growing nicely until middle of the last decade when growth stalled / industry matured due to EM ATM maturation. Installed base has been steady over the past years sitting around 3.2 to 3.3mm units. Industry consultant RBR projects the current installed base to be flat throughout 2025, with ~300k shipments (replacement) expected annually

ATM-related products/services isn’t a growth industry but doesn’t appear to be in secular decline either. ATMs are a critical delivery channel at the end of the day and are effective interaction points with retail banking customers in a world of declining B&M banking branches (USD and EUR note circulation has been growing, not shrinking). 

There has been some innovations in the ATM space such as ATMs with cash recyclers – that can more “efficiently store cash” for banking customers, so banks don’t need to leave excess cash earning 0% rate at the ATM location. There is still a runway of ATM fleet to be refreshed to have updated functionality to enhance ease of transactions

DBD has an attractive ATM product line-up called DN Series that may help it win market share in the next 2 years

DBD has materially shrunken its ATM product SKUs and is betting the future on DN Series with multiple innovative features that the banking industry is interested in:

• Certification process (150+ to date) and expectation is for material roll-out / shipment (critical mass) of 2H 2021

• Translating to rising product backlog as of YE2020: DN Series with cash recyclers can have 2x or higher ASP vs. cash dispenser

• Modular architecture for better upgradeability and 4th gen cash recycling IP are the differentiators of DN Series

Servicing efficiency should also improve meaningfully with DN. For example, advanced IoT and machine learning will drive higher availability for the latest line of ATM

DBD has also been launching next-gen software to drive higher-margin revenues and increase software attachment rate

Management has been driving material cost savings through executing DN Now Initiatives and improving DBD margins

DBD announced the DN Now Initiative in 2018 after the poor integration post Wincor Dixdorf acquisition. Initial gross cost saving target was for $250mm by 2021, and that has been increased to $400mm in early 2019, to 440mm in early 2020, and $500mm by mid-2020

Source of cost savings: ~1/3 from streamlining op model (labor force reduction), ~1/3 from G&A spend reduction (IT/procurement/real estate), and remaining from modernization of services/maintenance business

Timing of realization

• $175mm  in 2019 (started in late 2018)

• $165mm in 2020

• $160mm incremental savings expected in 2021

$500mm cumulative gross saving is very meaningful given DBD’s consolidated EBITDA was only $320mm in 2018 (declined from 382mm in 2017) when this initiative was announced. For example, $500mm is 12% of DBD’s entire cost base in 2018 (incl. COGS)

DN Now isn’t just an Operational Excellent initiative but is also aimed at repairing balance sheet given high leverage in back in 2018. Working capital improvement has been meaningful. Debt maturities have been refinanced out, but still have ample opportunities because weighted average interest cost is very high

Although COVID hit DBD hard from topline perspective (installation delays), DN Now allowed DBD to demonstrate resilience on EBITDA profitability 

Drivers of gross margin improvement

Products: disciplined bidding, favorable product mix, partially offset by lower manuf. absorption

Services: modernization progress, streamlined use of contractors, higher utilization of internal service teams, divested lower-margin businesses

Software: improving professional services utilization, optimizing third party labor, more cost-effective use of global delivery services

DBD has a valid plan to improve FCF conversion and quality of earnings

DBD has been trading at depressed valuations on outer-year EBITDA and EPS metrics due to low quality of earnings -- lack of FCF generation

However, it has multiple levers to improve FCF conversion and is targeting ~50% EBITDA to FCF conversion by 2023 including:

Continued EBITDA growth from a combo of top-line recovery and DN Now efficiency initiative

The fall-away of cash restructuring charges: this has been a brutal drain on cash for last 2-3 years but 2021 will be the last year of meaningful cash restructuring charges

Reducing interest payment: through both debt paydown and refinancing of $1.5bn of bonds with ~9% average coupon

Working capital improvement: there is additional NWC efficiency gain to be made, DBD took a step backward in 2020 but will recoup the efficiency in 2021 and beyond

Discplined CapEx: CapEx hasn’t been too high at DBD as it is transitioning into a less capital intensive business, but 2021 has a one-time IT transformation growth project that would fall away in 2022 and beyond

Multiple high-coupon notes are soon / now callable

I believe the 2021 guidance is likely conservative for the following reasons

Mgmt is taking a very cautious approach given visibility is only “great” in the 1H and they’d rather be safe rather than sorry given what COVID did to the stock initially

There was $200mm+ of revenue reduction in 2020 due to unplanned installation delays related to COVID – none of that was cancelled or lost, so the rebound of that itself is a 500bps growth tailwinds (a matter of when, not if)

Product backlog at YE2020 is already up 23% YoY (DN Series ATM is a big driver)

The flow-through from 160mm planned DN Now incremental gross saving to net EBITDA drop-through is very conservative, baking in material reinvestment (but discretionary)

I have EBITDA to FCF conversion at 34% in 2021, rising to 45% in 2022 and 48% in 2023 (close to the ~50% mgmt target)

That is $3.2 of FCF per share by 2023 – or 23% Pro-Forma FCF yield

Adjusted Net Income to FCF conversion should be above 100% as “mid-cycle” CapEx is smaller than depreciation (which takes time to trend down)

I’m assuming they refinance $1.1bn of notes with low-9% average coupon into new notes at 6.5% coupon by 1H 2022 after further deleveraging in 2021

Valuation

This idea is NOT about being differentiated on earnings vs. Consensus because the potential and targets have been very clearly communicated by mgmt. Rather, it’s about actually getting paid a multiple upon execution (the stock’s price doesn’t imply the market believes it)

I think DBD is worth 100% to 150% higher over the next 2 to 3 years in the base case at ~11x PE & 9.5x FCF

That also triangulates into 7.5x EBITDA. Historically 7.5x NTM EBITDA is the lower-bound of valuation, DBD was trading at 8x to 10x NTM EBITDA for years before the DBD-Wincor Dixdorf M&A blow-up

What will drive the re-rating? DBD needs to have a meaningful dividend payout to drive FCF multiple expansion (post deleveraging)

DBD used to be a consistent dividend payer pre Wincor Nixdorf acquisition and was happily held by dividend based investors (60%+ avg payout ratio). I think dividend can restart by 2023 after reaching < 2.5x ND/LTM EBITDA

Risk

Risk is just execution given the low level of industry growth rate, opaque nature of the cost structure, and relatively high financial leverage. We don’t really have data to model this biz on a granular basis, and s**t can go wrong in a way that is difficult to predict ex-ante. 

Can we trust management? The current mgmt team has delivered on execution so far after taking over the company when it almost filed for bankruptcy post levered acquisition

How much do you lose if I am wrong? You could argue it’s already priced like a “bag of crap”. Average levered FCF in 2019, 2020 and 2021 is almost exactly ~$100mm and that is with $100mm+ avg cash restructuring and very high interest expense (and this has been a period of reorganization + COVID impact)

Stock currently trades only 11x on this trough-ish FCF. While there may be some temporary downside on weak execution, I see the risk reward being attractive unless there is something really sinister (e.g. we are just being lied to / cash flow is not real at all)

Lastly point: this is a levered smid cap equity that was near bankruptcy once, so please size accordingly regardless of what you think the return potential is

Catalyst

Earning beat and raise
FCF conversion improvement
Dividend resumption in ~2 years