Description

Investment Thesis

We believe Global Axcess Corp (GAXC) is literally the proverbial fifty cent dollar. The stock has been consistently trading in the $.50 cent range more or less over the last year despite what we believe is fair value that could be as high as $1.00 (if not higher) on account of numerous improvements to their business through several initiatives taken since GAXC was last written up in November of last year. With a sneaky right before the weekend filing announcing the "retirement" of Michael Connolly from his role as CEO this investment opportunity is quite timely  (the event was dated 12/5/11, Monday, yet the company took the liberty of waiting until it filed it on Friday in an 8-K with pretty much no color whatsoever on the "why" behind Connolly's departure).

Business Overview

GAXC is a provider of ATM services through either owned or merchant operations. Additionally, since 2009, the company engages in the DVD kiosk business (ala Redbox) though this segment has been a major drag on earnings and developments there over the last year are crucial to the story.

ATM Overview

On the ATM side, GAXC operates in two manners: Full Placement Program (Owned): GAXC contracts primarily with grocery stores and convenience stores to place ATM machines which GAXC owns on their premises. The store owners benefit from the additional foot traffic which an ATM can draw in plus negotiated fees which GAXC passes on to the store owner as compensation for allowing GAXC to place its ATM in the store's location. The second mode is through merchant contracts where store owners own the ATM and simply outsource the servicing/maintenance (basically all of the day to day logistics of operating the ATM) to GAXC. This side of the business is a much smaller portion of overall GAXC profits though the company does not break out revenue/EBITDA at the ATM level by contract type.

GAXC is one of the five largest ISO, or Independent Sales Organizations in the ATM space, meaning non Bank providers of ATMs (this was how they historically presented themselves in presentations; since then 2 of the five largest, EDC and Access to Money were since acquired by the largest player, publicly traded Cardtronics (CATM) which leads us to conclude GAXC is likely the #3 player in the space by total ATMs).  The company does not give great a breakout on a unit basis (much less disclosure than either CATM on the ATM side or Redbox on the DVD side) but per talks with the company, as of 9/30/11, GAXC had 4,800 ATMs with 2,300 of them owned. Most were in the field generating revenue ("not many in inventory, dozen or two max").

ATM Revenue is primarily generated through a combination of surcharge fees set by GAXC but based on what nationwide banks charge for surcharge fees for non bank customer uses of their respective ATMs (per transaction; if banks raise surcharge fees as a means of generating additional revenue sources, it is trend positive for GAXC and other ISOs which can follow suit), and interchange fees (set by MasterCard/Visa etc.). The surcharge/convenience fee for most of the ATMs in GAXC's network range between $1.50 and $2.95 per withdrawal. On the interchange side, although ATM interchange fees have thus far been immune to coverage under Dodd-Frank, interchange fees are subject to rates set by third parties such as MasterCard and Visa. In fact, in 2009, MasterCard lowered the interchange fees for ATMs leading to a reduction of GAXC's ATM operating gross profits by approximately $30,000-$40,000 a month beginning April 1, 2010. GAXC has responded by successfully by raising surcharge fees which it did in Q1 2011 which flows directly to the bottom line on the ATM side assuming constant transaction volume and helping to defray some of the loss on the lowered interchange fees. From talks with industry observers, it is unclear whether Visa and the other major Network providers (such as Star & Nice) will follow suit. There is an argument that says that Visa may not want to follow suit (lowering the fees could lead to backlash in Washington as merchants get negatively impacted, something Visa may not want). All in all, as of now, the other Networks have not followed suit in lowering interchange fees though it remains a perpetual risk (to be potentially offset by increased surcharge fees, especially as banks lead the way as they look for new revenue sources in the post Dodd-Frank era).

Maintenance capex for the machines flows through the income statement (it is outsourced) so in theory barring growth, there should be no capex associated with the ATM business making EBITDA a true proxy for potential cash flow generation. This is not entirely true, however, as the expected life of a machine is about 10 years meaning 10% of all machines should need to be replaced every year at an average cost of betwene $2,500-$3,000. Assuming 2,300 owned machines, this would mean 230 * $2,750 = $632K of so called replacement capex a year. Management has told me they expect maintenance/replacement  capex (inclusive of spend to replace those machines which are not ADA compliant) to be closer to $450K a year over the next few years.

Payback periods for new machines placed are typically 12-18 months - with contracts typically 3 years or more, this means after 12-18 months through the duration of the contract, the cash receiveed is a return on and no longer return of money. Importantly, there are switching costs (albeit not tremendously high) with switching an ATM provider as your service gets disrupted so customers typically renew with GAXC. We have spoken with several large customers of GAXC who have raved about the GAXC service and said they do a great job for what that is worth.

ATM Industry Dynamics

The ATM industry is a fairly saturated industry with ~400K or so ATMs deployed nationwide (Pg 396 although dated gives a sense of historical ATM deployment over the last few years http://www.bis.org/publ/cpss95.pdf). From a channel check, there has still been some new placement growth despite the overall deployment staying in the 400K range as some poorly placed machines have been taken out of service netting against any new ones put in. This is definitely not a growing industry and over the long term likely in slow secular decline but the industry outlook is nonetheless stable as cash usage overall has been growing albeit as a percentage of total payment has been declining as part of the global shift to plastic. Growth for any of these ATM companies is likely through combination of large new accounts still out there and rolling up small Mom & Pop ATM portfolios (the latter can be very accretive). Recent ADA related upgrade requirements (supposed to be implemented by March of 2012) currently provide an opportunity for larger players like GAXC to purchase portfolios of ATMs from smaller players who are unwilling or unable to support the reinvestment required to become ADA compliant offering new growth avenues for companies like GAXC, albeit through M&A and subsequent required capex spend. Various industry reports indicate that ATM transactions are not expected go away and while growth may be limited, any argument for the death of cash is one which will take a very long time to play out. Accordingly, we would characterize the expected continued use of cash as steady and from a secular standpoint flat to slightly growing but in no way on a rapid decline downward.

Pre 2009

Pre 2009, GAXC was an attractive and more or less stable ATM provider. In 2007 and 2008, the company generated EBITDA of $3.7mm and $4.4mm respectively. Revenue in 2008 was basically flat with 2007 but financial performance benefited primarily from lower vault cash rates (due to lower interest rates) and increased surcharge fees on select ATMs. In 2007 and 2008, cash flow from operations was $2.5mm and $3.0mm respectively.

Entry into DVD: How we got to where we are today?

Everything changed when the company, driven primarily by former CEO George McQuain's desire to find new growth avenues, entered the DVD kiosk space. the company entered the space through the formation of a wholly owned subsidiary, Nationwide Ntertainment Services, Inc., in 2009. Through its branded DVD kiosks called Instaflix, GAXC is engaged in the business of operating a network of DVD rental kiosks. GAXC offers self-service DVD rentals through kiosks where consumers can rent or purchase movies or games. Current DVD kiosks are installed primarily at grocery stores. Since inception, this business has been extremely controversial for GAXC as it has required significant cash outlays and, despite its short history, has already incurred significant asset write-downs. The original DVD contract was at A&P (which recently filed for bankruptcy). From a June 2010 presentation, just around when the contract was signed hopes seemed high. This was GAXC's first major DVD win and was a 3 year contract expected to bring in $7mm in revenue a year. Things did not go as planned and 2010 DVD revenue maxed out at $1.3mm causing significant cash burn on the DVD side (negative $1.7mm in EBITDA and a net loss of $2.1mm not too mention the several million spent just to enter the space. The company spent $6.6mm in 2010 to build out its DVD portfolio (although some of the spend was for additional ATMs as well). All the while, throughout 2010, ATM segment level EBITDA (pre corporate SG&A) declined from $4.3mm in 2009 to $3.6mm in 2010 leading to an overall decline in company-wide Adjusted EBITDA from $4.7mm in 2009 to $2.7mm in 2010. The decline on the ATM side was due to the lowered interchange fees noted above as well as higher vault cash costs and increased insurance and maintenance costs.

            The stock market responded in turn as fears emerged regarding the core ATM business (had just experienced material decline) plus DVD was clearly not the cash cow everyone envisioned. The stock cratered throughout 2010 from the $1.00 level in early 2010 to the $.55 range by year end.

            On January 1, 2011, the company acquired all of the assets of Tejas Video Partners, an owner and operator of DVD Kiosks at through The Exchange, the entity which controls various stores on Army bases world-wide. With the Exchange contract, things start to get "exciting" and it is worth looking at the key events which I think make GAXC a much better positioned company today than it was a year ago:

New CEOs

2/28/11: Recognizing that CEO McQuain had led a disastrous effort entering the DVD space, the board of directors got rid of him, replacing him with two existing board members to serve as interim Co-CEOs: Lock Ireland (a long time board member) and Michael Connolly (who had only recently joined the board in November of 2010). They each were to be paid $12K a month though this was subsequently increased in an 8/8/11 8-K to $16K. It should be noted that Connolly was not living near headquarters and was expensig (until his recent sign off as CEO) close to $10K a month on T&E (primarily to fly in and out of Jacksonville, Floridawhere GAXC is headquartered). Connolly's removal should alone save close to $250K+ in annual costs going forward.

At this point, the major question was what the longer term strategy for company ought to be and how to best maximize shareholder value in a post McQuain world. Conolly and Ireland spent several months getting up to speed and devising a plan. Ireland was the supposed financial services expert having worked at banks and Connolly was hailed as a turnaround expert. From talks with numerous shareholders, there was a strong camp that thought this company had no business being an independent and public company given its size (per chats with the CFO, their public company costs range in the $750K range, obviously significant for the EBITDA the company has generated in recent years).

The basic plan which Connolly & Ireland outlined both publicly and through private chats with investors was that the aim was to 1) stabilize the DVD business, primarily on the A&P cash burning side and really focus on building out the Exchange which was viewed as a great opportunity; 2) to stay at it alone and implement a roll up strategy on the ATM side to continue to build that business. DVD focus it was stated would not be expanded beyond the Exchange and A&P.

ATM Developments Throughout 2011

While many may not like the roll up strategy idea, which we suspect was driven by Connolly, the company has succeeded in announcing some attractive deals over the course of this year:

The company announced two very attractive deals over the coming months following Connolly and Ireland's appointments as Co-CEOs:  On 5/17/11, the company announced a small deal where it acquired 23 ATMs for $118K. The portfolio acquired was expected to add $284K in annual revenue and $80K in annual EBITDA (1.5x EBITDA). On 5/24/11, the company announced its entry into an agreement whereby the company would provide up to 400 ATMs at stores of a national grocery chain (Save-a-Lot) with further opportunities through the chains' 900 franchisees. Finally, most recently, on 11/22/11, the company announced the purchase of a 238 ATM portfolio for $1.5mm. Additionally, management has told me they expect to spend approximately $100K annually for the 3 years remaining on the contract (37 months) as 50% of the machines or so needed to be replaced for ADA compliance (~$2,500 per machine assuming $300K spent and 119 machines). The portfolio is expected to add $2.4mm in annual Revenue and $880K in EBITDA (less $100K in capex so $770K in FCF) implying a purchase price of 2x annual cash flow (break even at year 2 with third year return on, not of money). Attractive deals like this give confidence to the 'stick it alone' camp and if GAXC can continue to do deals at attractive multiples like these, there may be a strong case to be had for sticking it alone. Investors would need to be confident though that there really are more deals out there at a large enough pace to be meaningful. The company expanded its internal M&A division earlier this year but to date only announced these two acquisitions and the 400 ATM new contract win.

Year to Date, the ATM business has put up extremely impressive numbers generating $1.7mm in Q3 2011 and $4.9mm in 9/30/11 YTD EBITDA respectively. The company does not give unit level detail like CATM so it is difficult to disaggregate the unit economics to really build a unit based revenue/EBITDA build since the pieces are always moving without full clarity from the company as to how many machines were in force at a given time. If we take a haircut to Q3 and assume say $1.5mm in run rate EBITDA, that annualizes to $6mm in ATM EBITDA. Add $880K from the new deal and ATM segment is running close to $7mm in segment level EBITDA.

Food Lion

The biggest overhang on the stock currently is a contract with Food Lion, the company's largest and most profitable account which is currently on a one year auto-renewal despite GAXC having serviced the relationship since 1996. The company is engaged in intense negotiations to try and win a renewal with Food Lion which would also likely include the ATM contract at the Hannaford grocery chain controlled by Food Lion as Food Lion wants to consolidate its ATM provider. Our channel checks indicate that Food Lion really likes GAXC and thinks their service is excellent. Furthermore, the incumbent on the Hannaford side against which GAXC is competing is much smaller (Hannaford has a smaller footprint) and it is unclear if they have the financial muscle to handle both the Hannaford and Food Lion contracts). Nonetheless, Food Lion has indicated that the decision will be a blend of price and relationship/feedback from the customer contacts at Food Lion that handle the account. It is unclear how this will shakeout but management seems very optimistic that they will win the account (this despite the fact that Connolly was supposedly leading the Food Lion effort and he has just left his post as CEO with no news yet on the Food Lion Front). If they lose the account, they are losing ~20% of revenue and ~25% of Gross Profit (higher margin contract at Food Lion than elsewhere). Before the newly announced deal, annualized Q3 Gross Profit was about $11mm for ATM. The number will be coming down slightly due to renegotiated maintenance contracts which will have slight negative impact to margins. In a worst case Food Lion contract gets lost scenario, the business should still do about $7.5mm-$8.5mm in ATM Gross Profit plus an additional $880K from the new deal leading to run rate Gross Profit of $9.4mm. Subtract out ATM SG&A of ~$4.2mm and you get run rate ATM EBITDA post Food Lion of $5.2mm.

DVD Onslaught

Ignoring Food Lion, as the ATM business has continued to generate significant EBITDA, things on the DVD side continued to get worse throughout 2011.  Despite the sluggish start at A&P, the company continued its expansion plans on the DVD side and effective January 1, 2011, the company acquired the assets of Tejas Video Partners, LTD, for ~$1.5mm. Tejas has an attractive contract to operate DVD kiosks at stores operated by the Exchange, the entity which  controls various stores on Army bases world-wide. As the A&P contract proved to be wildly unprofitable, in Q2 of this year, GAXC began transferring kiosks from less profitable A&P locations to locations at The Exchange, helping defray initial expected capex spend for new DVD kiosks at the Exchange. This resulted in significant cash outflow (due to the moving and rebranding as well as lost revenue during the transition) and was compounded by an announcement in GAXC's Q3 press release that through their bankruptcy, A&P was cancelling all of the remaining outstanding DVD contracts resulting in a $1mm write-down on some of the assets which had been at A&P. Currently, the success of the DVD hinges on GAXC's operation and ability to profitably grow the business at The Exchange. In its Q3 2011 release, management separated out legacy DVD (A&P) from the Exchange to try and tell the story that it is not the entire DVD business which is in disarray and that the Exchange has much promise. Management thinks that run rate EBIT is at a minimum ~$1.2mm for DVD. Unlike the ATM business where as noted EBITDA is a close proxy for cash flow (ignoring replacement capex and given maintenance capex flows through the income statement), EBIT is a better metric to use for the DVD side since what management terms Amortization of its DVD library, while technically non cash is pretty much matched with a required annual inventory build of new DVDs. Accordingly, the amortization add back on the cash flow statement would be consistently negated by a working capital build in inventory. Although misleading, per chats with the company, the EBITD"A" which the company reports is actually NET of the Amortization as the accounting effectively nets the amortization "expense" against inventory build on the cash flow statement and thus in actuality, EBITDA is what we would typically refer to as EBIT which given the point on inventory build is a good proxy for cash flow.

The basic math getting to $1.2mm in run rate EBIT for the Exchange is as follows (uses rough assumptions per talks with management):

Of the $1,500 in fixed costs ~28% of that includes the amortization of the DVD library (GAXC assumes 12 month life) with the remainder basic fixed costs with running the kiosks. $2,300 is the assumed average revenue across the 202 kiosks currently in place. Incremental revenue would not all flow to the bottom line due to variable costs which the company has told me are less than 35% so each incremental dollar above $2,300 should yield at least $.65.

Connolly's Leaving as CEO

To anyone following the company the last few months it comes as no surprise that Connolly has left the company. He was the big driver of the stand alone model and mysteriously was missing from the Q3 earnings call as he was busy working on the Food Lion contract (We think many investors took that to mean he was being phased out; hard to imagine he was spending 24 hours a day on trying to renew a single contract to the extent that it prevented his participating in the earnings call). For those who are in the "sell the company" camp, this may bode well.

Cardtronics: The big Elephant in the Room

As noted, there is a strong constituency among the shareholder base, many of whom have gone vocal on the subject on earnings calls, notably Russell Cleveland, the largest shareholder, who favor a sale of the company. Cardtronics (CATM), the largest player in the space has been playing the role of consolidator and in the last few months announced two significant transactions which whet the appetite of pretty much every GAXC shareholder:

1) EDC: On 6/21/11, CATM announced the acquisition of EDC Holding Co for $145mm. EDC has 3,700 ATMs (assuming they are all owned then it is about 60% larger than GAXC, ignoring GAXC's non owned portfolio; on a per ATM basis that would imply $20,270 per owned ATM. Applying the same math to GAXC's 2,300 owned ATMs leads to an implied GAXC valuation of $47mm). EDC, however, arguably has a better portfolio than GAXC as it has a strong franchise on the bank branding side so it is difficult and likely incorrect to look at these transactions on a per ATM basis. From talks with people in the industry, I gather than the best way to value these assets is on a Gross Profit basis as given the ease with which portfolios of ATMs can be rolled up into an existing but much larger portfolio such as CATM's without incremental SG&A, the real question is how much gross profit the company is adding. From press releases, it seems EDC was doing about $60mm in revenue. Assuming CATM's Gross Margin of about 33%, this would imply a Gross Profit for EDC of about $20mm. That would mean that CATM paid 7.3x EDC Gross Profit.

2) On 8/15/11, CATM announced the acquisition of Access to Money, a publicly traded ISO which predominantly had service contracts as opposed to owned ATMs (10,350 ATMs managed). Access to Money was suffering from a heavy debt load so there was minimal equity value in the transaction. The transaction value was $21.2mm inclusive of debt assumed with potential for a $5.3mm subordinated note payout which would lead to total payout of $26.5mm. Here are the multiples for the deal (Access to Money was publicly traded so we can calculate their EBITDA and Gross Profit; we have utilized LTM and H1 annualized to account for shifts in their business due to a major contract loss that occurred in Q3 2010):

This is obviously a wide range as it is clear Access to Money was barely profitable due to its SG&A costs which should mostly go away under the CATM banner. The right multiple for a comparable company's Gross Profit is likely somewhere in between the two multiples and more in line with what was paid for EDC albeit with a haircut due to the highly attractive nature of EDC's bank branded business.

 Valuing GAXC Today

The big question that emerges when trying to pin a value on GAXC is first determining what is the best way to maximize value for GAXC: as a standalone entity or through a sale process. If sold, the most likely buyer would be CATM for the ATM business and either Redbox or NCR for the DVD business (interestingly enough, the DVD industry is highly fragmented and we have seen references indicating that after NCR and Redbox, GAXC is actually the third largest player. We have not been able to verify this though). CATM has drawn down its revolver to make the two acquisitions noted above yet has maintained it still has an appetite for further M&A. In contrast and almost strangely, on its conference calls, when asked about other players in the space, CATM makes no mention of GAXC as a significant player with a large installed owned base despite having more than half the number of owned (assuming all of EDC's ATMs are owned) as EDC. We got a similar sentiment from the CATM CFO when we spoke with him a few months back and got the official impression that they do not even have GAXC on the radar screen though we find this hard to believe.

Either way, in thinking about valuation, what do we have:

Assuming a sale and the two businesses are valued off of Gross Profit, applying conservative multiple estimates (again given nature of how easily kiosks can be rolled up into a large operator with virtual elimination of much of SG&A, paying 4-5x Gross Profit is not much different than paying 4-5x EBITDA for a different type of business acquisition; not too mention ATM in particular has a stable and attractive cash flow profile):

 We should mention that GAXC has a $23.6mm NOL which at the current Long Term Tax-Exempt Rate (LTTER) of 3.55% would add 3.55% in annual tax shields times the equity value in the above scenarios. 

As a stand-alone entity, and presumably valued off of EBITDA, the run rate EBITDA for the ATM business is around $7mm with Food Lion renewed and $5.2mm without Food Lion renewed (both cases pro forma for the 11/22/11 acquisition which adds $880K of EBITDA). Add to that about $1.2mm minimum EBITDA for DVD (what the company terms EBITDA but is likely closer to EBIT in typical usage due to its inclusion of the amortization of the DVDs as noted above). To get consolidated EBITDA, subtract out about $2mm for corporate SG&A. This gives a Food Lion and non Food Lion EBITDA range of $6.2mm to $4.4mm.

As a point of conservatism, we are giving no credit to the $1.2mm in cost savings which management has identified yet has not shown up in the numbers. There have been so many moving pieces (new ATM deployments, acquisitions, DVDs moving around, Exchange ramp up) the last quarter that distilling run rate numbers is quite difficult. We have tried to come up with reasonable run rate assumptions with added levels of conservatism such as ignoring these savings. Our current view is that we will believe and add them to the numbers when they are already in the numbers, i.e. when we see them actually in place.

We can argue all day long as to what is the "right" EBITDA multiple for this type of business: 0.0% effective tax rate for the foreseeable future due to its NOL's ought to make its EBITDA more valuable than in other situations. Furthermore, in theory as noted maintenance capex flows through the income statement which again makes EBITDA all the more valuable than in other situations. If one was truly running this for cash on a steady state basis, FCF might look something like this:

Assuming management can "right" the business and truly begin to show the cash flow it is capable of, even a 15% FCF yield (say its demanded due to it being a microcap, there is some leverage, DVD still unproven, illiquid stock), would lead to the following valuation:

No matter which way you slice it or dice it, we believe GAXC is materially undervalued at current levels. There is a significantly concentrated shareholder base which we believe is a major positive as you can probably get over 50% of the vote through roughly ten individuals. Accordingly, if there is consensus that a sale to CATM/NCR/Redbox or anyone else is the best way to maximize value, shareholders can easily rally together to force management's hand. With Connolly out of the picture, this may be just the plan management will look to take as Connolly had been the major proponent of the stay it alone option. Until Food Lion gets resolved, however, either way it ends up shaking out, we believe the company is in no position to market itself for sale. Once the Food Lion overhang gets removed, GAXC will be a cleaner company and much better positioned for a sale should that be the chosen option (no overhang/uncertainty on key contract, no cash burn from A&P, more mature results finally flowing through from the Exchange as it was only 9/30/11 when all of the initial 200 or so machines were up and running and it takes at least 60 days to get to run rate numbers since a portion of revenue comes from DVD's purchased when not returned and this only takes place after 30 days of rental so need to be be inclusive of all the 30 days past rental including the 30th day of the first month which means you dont have a real run rate sense for the machines until day 60 which assuming all were ramped up on 9/30/11, would just have come into play in December meaning even Q4 2011 will not have a real run rate yet for the Exchange (will only have a month or so).

As a sanity check to valuation, we have heard from consultants/M&A advisors in the industry who believe GAXC is worth at least $.70 without Food Lion and at least $1.00 with Food Lion.

Catalyst