Description

This is a recommendation for a short sale of EPIQ Systems, Inc. (“EPIQ”) common stock.

Summary:
EPIQ is a national provider of the software and hardware used by trustees to administer Chapter 7 and 13 bankruptcies and companies to administer their Chapter 11 reorganizations. Do not mistake this company for a software company. Their revenues are derived as a percentage of the assets being liquidated by trustees in Chapter 7s, the number of claims in Chapter 11s and the size of the caseloads and volume of notices generated in Chapter 13s. The company currently trades at 11.7x 2002 Adj. EBITDA and 28.0x 2002 Adj. Net Income. I believe that both these earnings numbers are at or close to their peak. The company also trades at 11.2x tangible book value of equity. The thesis for this investment is simple, the current price of this company implies a growth that I do not think will materialize given the current slow down in bankruptcies. As the number and size of bankruptcies slow and their administrations come to a completion, the growth in EPIQ’s revenues and earnings will slow dramatically and begin to decrease from its peak during the last couple of quarters. For those of you that liked the FTI Consulting short recommendation posted by quentin720 back in April (and I place myself in that category), this is a similar concept. Like FTI, an EPIQ short is not a question of if, just a question of when.

Business Description:
EPIQ is a national provider of technology-based products and services to law firms and attorneys who work in the federal bankruptcy system and to companies that have filed for bankruptcy reorganization. The products automate various administrative tasks relating to bankruptcy claims, assets, financial records and other data associated with liquidations and reorganizations.

Chapter 7s are corporate or personal liquidations and are administered by a US trustee. For Chapter 7s, EPIQ’s business model is to provide the hardware and software to the trustee at no direct charge, but then to earn a fee based on a percentage of the assets being liquidated. EPIQ has a marketing arrangement with Bank of America by which, in exchange for providing the hardware and software to the trustee for free, trustees agree to deposit collections with Bank of America and EPIQ collects from Bank of America monthly revenues based on a percentage of the liquidated assets on deposit and on the number of trustees.

Chapter 11s are corporate reorganizations and are administered by the company reorganizing. For Chapter 11s, EPIQ provides the technology and professional services to the debtor’s lawyers and collects a monthly fee based on the number of claims in each case and on a time and materials basis for the professional services (sometimes these services will also be done on a fixed-fee basis).

Chapter 13s are individual reorganizations. For Chapter 13s, EPIQ provides a software package and collects revenue based on the size of the caseloads and the volume of notices generated.

EPIQ acquired Bankruptcy Services LLC (“BSI”) on January 31, 2003 for $67 million ($45.5 million cash, $16.5 million in restricted shares and $3.5 million in a non-cash pay note) to add more Chapter 11 business. I estimate that EPIQ paid approximately 4.8x 2002 EBITDA for BSI. BSI provides technology-based case management, consulting and administrative services for Chapter 11 cases. BSI’s products are being used to administer the reorganizations of Worldcom, Enron, Global Crossing and Adelphia, among others. I believe from talking to management that BSI will be selected to administer both Mirant and Loral, which is one of the reasons the stock was up so much today.

EPIQ derives approximately 57% of their revenues from Chapter 7s, 10% from Chapter 13s and 33% from Chapter 11s. They do not break out how much of their Chapter 7s are corporate liquidations versus individual liquidations, but my best guess from talking with management is that approximately 75% of their Chapter 7 revenue comes from corporate liquidations. Put this together with their Chapter 11 business and approximately 76% of their total revenue is from corporate bankruptcies as opposed to personal bankruptcies. I think this is important because I believe that personal bankruptcies have not yet peaked while corporate bankruptcies have and are already on the decline.

Bankruptcy Market:
I do not think I need to spend a lot of time explaining the current state of the bankruptcy market. Anyone who reads the papers regularly knows that bankruptcies were at an all time high in 2001 and again in 2002, and that the number and size of these bankruptcies has dropped off considerable in the first half of 2003. I think that the Mirant filing will be one of the last massive filings of this business cycle. Total number of business filings peaked in the 2nd quarter of 2001 with 10,330 filings and is down almost 15% in the 1st quarter of 2003 with 8,814 filings. Total business filings in 2000, 2001, 2002 and Q1 2003 annualized were 35,323, 39,885, 38,403 and 35,256, respectively. The trend in the size of pre-petition assets of public filings is even more telling: $14b in 1996, $17b in 1997, $29b in 1998, $59b in 1999, $95b in 2000, $259b in 2001, $368b in 2002 and only $49b annualized for the 1st quarter of 2003. With Mirant and Loral filing for bankruptcy today, this number will look higher once 2nd and 3rd quarter data is available, but I think the trend is clear.

Individual bankruptcies have held up better, but this is such a small part of EPIQ’s business that I do not think it matters much. Non-business filings peaked in the 1st quarter of 2003 at 404,154. With high consumer debt and future rising interest rates, individual bankruptcies will probably stay high, but that will not be enough to counter the negative trend in corporate bankruptcies.

Valuation:
To understand the financial performance of EPIQ post the BSI acquisition, a good starting point is EPIQ’s 8-K filed on March 25, 2003. That document gives pro forma combined financials for 2001 and the 9-month period ending 9/30/02. You then need to make some assumptions as to what Q4 and Q1 2003 looked like on a pro forma basis. The actual Q1 results include BSI results from January 31 only. My assumptions give me the following financials (in millions):

2001PF 2002 PF Q1 2003 PF Q1 Annualized
Revenues $40.9 $61.1 $16.7 $66.8
Adj. EBITDA* $17.4 $30.4 $8.3 $33.3
Adj. Net Income* $5.5 $13.2 $3.8 $15.3

*All results are adjusted for one-time costs. I used a 38% tax rate for the NI adjustments.

The business is not seasonal and thus I think annualizing Q1 is a good starting point to get a current financial picture. It is certainly possible that Q2 financial performance will continue to show growth and/or margin improvement as bankruptcies often take many years to complete and there are probably some synergies associated with the BSI acquisition and other costs that can be removed, but I do not believe that things will get much better from here unless there is another massive wave of corporate bankruptcies. Current valuation using my annualized Q1 numbers is the following:

Debt $4.1
Cash $15.9
Diluted Equity $369.1
Enterprise Value $357.4
EBITDA Multiple 10.7x
P/E 24.1x

There are not any pure-play publicly traded comps. Competitors include Donlin Recano & Co., BMC Corp., Poorman-Douglas and Trumbull Bankruptcy Services, all of which are private companies. The company also competes with JP Morgan Chase for the liquidation business. The best acquisition comparable is EPIQ’s acquisition of BSI, which I estimate to be at 4.8x 2002 EBITDA.

While it is not unheard of for a growing, free-cash-flow positive business to trade at 10.7x EBITDA or 24.1x Net Income, for a business whose primary revenue stream is most likely about to decline substantially to trade at such premium multiples is suspect.

Risks:
We are too early and EPIQ posts another quarter or two of excellent results (they will win the Mirant and Loral business)
Double-dip recession creates another massive wave of corporate bankruptcies
High consumer debt levels coupled with rising interest rates creates a massive wave of individual bankruptcies
EPIQ finds other targets to acquirer creating the illusion of growth
Liquidity - EPIQ is not the most liquid name out there (avg. daily volume = ~110K)
Normal risks being short stock

Conclusion:
With a typical bankruptcy lasting approximately 18 months and substantially fewer new bankruptcies, EPIQ’s top-line growth should grind to a halt and begin to decrease over the next couple of quarters. Once the market realizes that EPIQ is no longer a growth play, it should command a more reasonable valuation. At 5x 2002 EBITDA, which is a higher multiple than what EPIQ paid for BSI and is probably at or close to the peak EBITDA, EPIQ would trade around $9 per share. At 5x a more reasonable, mid-cycle EBITDA, EPIQ would trade in a mid-single digits range. As with FTI Consulting, I do not think this is a question of if, just when.

Catalyst

Bankruptcies continue to slow as the economy rebounds (or just does not get worse)
EPIQ’s current portfolio of bankruptcies rolls off
Quarterly reports begin to show the slowing and eventually ceasing of top-line growth