Description

We believe Hypercom (HYC) offers a compelling risk/reward profile and the potential for a double or more over the next year or two.

HYC is a provider of point-of-sale (POS) terminal devices (80% of revs.), specialized networking gear, and transaction transport services (together 20% of revs.). Roughly 2/3 of revenue is international. POS terminals are simply the physical device that allows merchants to accept card-based payment. The networking gear is specialized equipment used for routing transactions. Transaction transport services provide the data transport from the POS terminal to the financial processor.

The company competes with Verifone (privately owned by GTCR, recently filed S-1), Lipman Engineering (public Israeli company, NASDAQ: LPMA) and Ingenico (public French company). The annual market for POS terminals is around $2 billion. HYC, Verifone and Ingenico together control around 60% of the market with HYC at around 20% share. Lipman is considered the class of the bunch (and valued as such) with a fast growing wireless terminal component, extremely efficient operations and an excellent management team. Our channel checks indicate that HYC is perceived as having a very good product portfolio that is on the leading edge of functionality. In fact, the company won the Frost & Sullivan award for their category in 2002 and 2003. Management (now terminated) left little to be desired.

WHAT HAPPENED?

The company took on "red-headed stepchild" status back in July 2004 after management disclosed that it would take a $12.9 million charge related to a contract with the Brazilian Health Ministry. They followed this up in October by announcing that a component shortage would delay product shipments (thereby taking results below consensus) and revealing a renegotiated contract with First Data (its largest customer) that increased revenue but compressed margins. They again lowered guidance on December 20th due to a mix-shift to lower margin products and onerous Sarbanes-Oxley costs. And not to be outdone, they came out in January to announce that they would have to convert its U.K. lease portfolio from a sales-type lease to an operating lease which would effectively reduce revenue and operating income in the first three quarters of 2004 by $4 million and $3 million respectively. But wait, there’s more……the board canned both the CEO and CFO in the past week. How's that for a lot of hair?

Mr. Market was none too pleased and has lopped off around $50+ million in market value since the lease announcement and $200+ million from its high in June. With roughly 52 million shares outstanding and a price of $4.70, HYC currently trades at a market cap of about $245 million. Before getting into why you should own this beast, I think it will be helpful to address the issues above.

1. Brazilian Health Ministry.

The company took a $12.9 million non-cash charge to cover receivable and prepaid expenses associated with a contract for the development of a national healthcare system in Brazil that would monitor patient eligibility and facilitate record keeping. In May of 2004, Brazilian authorities initiated a formal investigation into all of the contracts outstanding at the Health Ministry due to alleged corruption specifically related to blood plasma purchases. As a result, payments on all Health Ministry contracts have been suspended pending review (every contract, not just Hypercom's). There is no indication that these investigations have anything to do with HYC.

OUTLOOK: Although HYC took the entire hit in Q2, there is no dispute about what the company is owed and Brazil has begun to make the payments. We believe the balance should come in through 2005. If we give the future payments a 15% haircut, it would provide roughly $7 million in after-tax cash.

2. Component Shortage.

The company deferred the shipment of some of its new multi-lane POS terminals from Q3 to Q4 due to an issue with the availability of the terminal's color screen component. The company had a single supplier for this component and was notified that the supplier couldn't meet HYC demand to spec. Management engaged a second supplier and quickly got the vendor certified. Subsequently, the original supplier came back and told HYC that they had fixed their issues and could supply the needed number of components at the required spec presently and in the future.

OUTLOOK: While this was disappointing and certainly a management blunder, it was merely a deferral in shipping product that would eventually be monetized. The orders are there. Moreover, we think management had little choice but to defer shipment rather than put out lower quality product and potentially face a recall. Now, HYC has two certified suppliers of color screens, products are being shipped and the company is in position to meet increased demand for the new multi-lane terminals going into 2005.

3. First Data Contract.

FDC represents about 15% of HYC's revenue. A large concentration with FDC is fairly consistent among the other POS manufacturers since FDC is such a large buyer. HYC and FDC entered into a new contract for HYC to be the lead supplier of stand-alone terminals to FDC. Our understanding is that this is a long-term contract for HYC to supply 90% of stand-alone terminal demand for FDC customers.

OUTLOOK: The implication is that HYC will generate considerably more revenue and profit but at the expense of unit pricing and margin. On an absolute dollar basis, we view this as a modest positive. Plus, the long-term feature of the contract locks-down an important customer for years to come.

4. Product Mix-shift.

In December, management lowered guidance. A primary driver behind this was a greater order shift to the company's "Optimal Line," a new 32-bit family of terminals still in its initial manufacturing phase. This initial phase is characterized by an over-engineered (i.e., more costly) manufacturing process to facilitate speed to market. Once market acceptance occurs, then the manufacturing process is reengineered for cost optimization for a dramatic reduction in manufacturing cost. In addition, the company received more orders for multi-lane terminals and quick-service restaurant terminals, two markets that are generally very price-sensitive.

OUTLOOK: We believe the company will eventually optimize the manufacturing process. If you look back to prior new product launches, the same thing happens time and again and management has successfully brought manufacturing in-line. This does not happen overnight however, and will likely be an overhang for the next two quarters. The good news is that demand is strong for this new product family. The bad news is that until management can bring costs in-line, these lower-margin products will likely cannibalize the higher margin ( and older) terminals that have already gone through the re-engineering process.

5. Sarbanes-Oxley Costs.

Who doesn't have to deal with this? With HYC, we are in amazement at the expense it has cost the company. By management's estimates, we're talking $4 million in hard dollars and approximately $1.5 million in soft costs (wasting management time). The bulk of the hard cost is related to 404 compliance which is an ongoing event but most costly in the first year. The fact that they had to spend so much to get compliant indicates to us that there are weak controls inside the company. As much was revealed when the company announced the lease re-classification.

OUTLOOK: Sarbanes-Oxley is a way of life for public companies and the expense to deal with it will not go away. However, we believe that the bulk of the 404 compliance expenses are behind the company and the company will emerge in 2005 with much stronger financial controls.

6. Lease Reclassification.

This was the straw that broke the camel's back and caused the analysts to completely throw in the towel on the company. But what happened is rather simple. The company said it incorrectly classified its UK lease portfolio as a sale-type lease rather than an operating lease. Sales-types leases allow you to book more profit up-front rather than steadily over the life of the lease. The effect of the reclassification lowered revenue and operating income in the first three quarters of 2004 by $4 million and $3 million respectively. The auditors (E&Y), being in ass-covering mode, issued an adverse opinion with respect to financial controls as a result of the reclassification.

OUTLOOK: BIG overreaction by the market in our view. The reclassification does absolutely nothing to impair the lease value nor does it have any affect on cash flow. The company could sell the leases tomorrow for around $28 million. Had they sold it earlier in the year as previously planned, this would not even be an issue. In fact, we hear that FDC will be buying back their portion of the leases in the neighborhood of book value which would provide HYC $20-25 million in cash.

7. Shareholder lawsuits.

The lawyers didn't waste much time to recruit shareholders to sue the company. They have D&O insurance but I haven't a clue how to handicap the suits. For valuation purposes, we'll back out $10 million in settlement costs. But it’s worth noting that the company said that their internal investigation indicated there was no misconduct.

OUTLOOK: A toss-up but given the circumstances, it doesn’t seem that the shareholder suit has much merit. For valuation purposes, we will assume a $10 million settlement.

8. Management Changes

The company announced over the past week that the CFO would be leaving the company and later that the CEO would be retiring. The fact of the matter was that they were pushed out, plain and simple. We view this as an extraordinary opportunity. Management has been the poorest allocator of capital that I have ever witnessed. They also were pursuing a path that we believe would have been fruitless. Basically, Alexander (ex. CEO) wanted to leave a legacy at the company by building up the HBNet business. HBNet is the transaction transport business and identical to TNS (NYSE). They currently control 85% of the Canadian market in partnership with Bell Canada. Recently Bell Canada indicated that it would like to sell this business and Alexander wanted to bid for it. So did TNS which has much better currency to do the transaction. We are not certain, but we think the transaction would have been in the $25 million range for Bell’s stake. Since HYC and Bell are 50-50 partners in the venture, then HYC share is worth the same.

Since Alexander was pushed out, the company has indicated to us they are backing away from this business. We think it is the right thing to do since the total market opportunity in North America is small (around $250 million), current providers are entrenched, and it is a pure commodity business. We are pushing for them the sell their stake in the Canadian venture along with Bell Canada.

OUTLOOK: This is best thing that has happened to the company in a long time.

OK, at this point I hope I haven't driven you away and you probably think I'm missing a few marbles for recommending this thing. So what's to like?

ENTERPRISE VALUE

The company should exit the first quarter with nearly $100 million in cash and we estimate that the U.K. lease asset is worth $28 million. Several entities have bid for this asset in the past but management has postponed the sale because First Data has told the company that if they sell the asset, it would be to FDC since most of the leases are with FDC customers. Since FDC is Hypercom's largest client, management tends to play ball with them. The problem with selling the asset to FDC, however, is that it would reveal proprietary pricing information that management would rather keep private. Whether sold or not, the leases are worth $28 million and will eventually convert to cash. We suspect the FDC portion will be done in the next 3 months. If you back out the cash and lease asset and add back an $8.5 million mortgage note and $10 million for settlements, the company's enterprise value (ex. real estate which will be discussed below) comes in at about $135 million. Also back out $7 million of the discounted after-tax value of the Brazilian Health Ministry payments and enterprise value falls to $128 million.

The company owns a significant amount of real estate. First, they own a 142,000 square foot office building in Phoenix, AZ. The property includes a lot of acreage. At $10 rent per square foot (very low for Phoenix market) and an 8% cap rate, the building is worth close to $18 million. Second, they own a 23,000 square foot office floor in Hong Kong. At $30 rent per square foot (very low for Hong Kong) and an 8% cap rate, the floor is worth about $8.6 million. Lastly, they own a 102,000 square foot facility in Brazil. At $4 rent per square foot (this is a pure guess) and a 10% cap rate, the property is worth about $4 million. Add it all up and you get around $30 million. Of course if they were to monetize the real estate, they would have to pay rent which, based on the above assumptions, would come out to about $2.5 million annually. Any way you slice it, the properties alone represent over 20% of their enterprise value. If you choose to back out the real estate, then enterprise value is $98 million.

Now also consider the HBNet business. If Bell Canada can sell their stake at $25 million, then so can HYC. The business itself is not material to HYC cash flow and, in our view, a complete distraction.

VALUATION

We believe that the top-line for 2005 should reach $280 million. In 2002 and 2003 (more normalized years), CFFO represented between 10-12% of revenue. Assuming the low-end, a normalized 2005 can generate CFFO of about $28 million. (As an aside, we know that internal guidance to the board is $30MM in EBITDA, plan is $35MM, and the former CEO believed the $30MM number would be a layup for what its worth). Back out $6 million for CAPEX and that's less than 6x EV/FCF or over 17% FCF yield on EV (giving no value to the real
Estate or the HBNet business).

Why should you have any confidence in these numbers? First, the revenue picture is very bright and second, we believe the board is on the eve of a restructuring that could make these numbers significantly higher. We also believe that they are considering strategic alternatives but have yet to announce so.

The main revenue drivers for Hypercom include 1) rapid worldwide growth of electronic payment transactions, 2) the looming EMV deadlines for merchants to convert to smart-card terminals (EMV is a standards consortium consisting of Europay, Mastercard and Visa), 3) rapid deployment of terminals in Asian countries, particularly China and India, and 4) new products and industry verticals.

I'll try to keep this short. According to the Nilson Report, electronic payments in the U.S. are expected to grow from 40% to 57% over the next five years. Other geographies are expected to grow even faster. The EMV deadlines in 2005 include Europe and Latin American, with Asia, Central America and Africa coming on line in 2006. We believe the deadlines will accelerate a massive replacement cycle for terminals because merchants that don't comply will be faced with the financial risk in the event of fraud. China and India deployments are accelerating. Many analysts believe this market will match the U.S. within the next three years. Finally, HYC has entered the QSR and multi-lane with new products that have been very well received. And the company's new IP product (allows dial-up terminals to work with broadband) is a new opportunity that is gaining traction.

The restructuring opportunity is significant. Operating expenses currently represent over 35% of revenue for HYC versus 29% for Verifone and 18% for Lipman. The company is on a run-rate to spend $27 million on R&D (10% of revs.) in 2004 which is expensed - a much higher percentage than its peers (LPMA is less than 4%). SG&A is currently running at 25%, also significantly higher than its peers. The remaining management team has confirmed to us that the combined percentage is too high and that they are working to bring it below 30% of revenue within a year. Any new management team could take $10 million our in a week or two. R&D has been characterized by insiders as “unfocused with too many non-core projects.” We think you can take out $10 million in costs through R&D alone. Regardless, if they can achieve a 30% expenses margin, the reduction would equal approximately $14 million (on $280 million in anticipated revenues) or half of our estimated CFFO number pre-restructuring. Even without a nickel on cost improvement, we still believe it is reasonable to assume that our estimate of $28 million in CFFO for 2005 is achievable but the potential is closer to $38 million

More improvement in costs can come from the currency hedging program which in years past has been absolutely awful. Every year the knucklehead running the program for them loses $2-5 million. Basically all they have to do is forecast the expenses (which are largely fixed) and hedge out movement in Swedish Krona. Or they could simply deposit money in a Swedish bank account.

VALUATION SUMMARY

Assuming you can buy into the above numbers, here’s a recap of the valuation. (pick and choose the components of enterprise value. I’ll simple lay them out as we see them

Market Cap $245M

LESS
Cash (Q105) $100M
Lease Value $28M
Brazilian Payments $7M
Real Estate $30M
HBNet Business $25M

PLUS
Mortgage Note $8.5M
Shareholder settlement $10M

EV (all-in) $73.5M


PRE-RESTRUCTURE

2005 CFFO $28M
2005 CAPEX $6M
2005 FCF $22M

EV/FCF 3.34X
EV/FCF 5.84X (ex. Real estate and HBNet)

POST-RESTRUCTURE (assuming $10M in after-tax cost saves)

2005 CFFO $38M
2005 CAPEX $6M
2005 FCF $32M

EV/FCF 2.30X
EV/FCF 4.00X (ex. Real estate and HBNet)


DOWNSIDE

The company has a tangible book value of $203 million which is calculated as stated book minus intangibles plus discounted value of Brazilian payments. This works out to about $3.90 a share or just over 15% below the current price of $4.70. Please keep in mind that the majority of this book is liquid so we believe it represents a reasonable floor for the stock price.

CATALYSTS

1. Imminent Restructuring.

We believe the board is ready to pull out the knife on operating expenses. LPMA and Verifone both have publicly available financials and both run significantly more efficient operations. Everyone we speak with makes it very clear that the company intends to get operations more in line with peers. When we asked if expenses could go below 30% of revenues, the reply was "easily." A new management team would certainly attack this sooner rather than later. Any improvement to the cost base is simply gravy based on base numbers for 2005.

2. New Management Team.

We have no idea who the new team will be (if it ever goes that far) but the changes that need to be made are apparent to the board and we have confidence that when they bring in a new CEO he will be mandated to execute them. A monkey could take $10 million out of costs and that would be nothing but upside on our forecasts. Moreover, the new guy will have the opportunity to set the bar low and begin to regain credibility for the company on the Wall Street.

3. Share Repurchases.

We believe that share repurchases will resume in the second quarter of 2005. Management has a $10 million authorization outstanding, most of which is still available. They purchased 60K shares in 2004 in the $4.50 area. It would be downright irresponsible for management not to purchase shares at this valuation. Any buybacks at this level would represent an excellent allocation of capital as we believe you are currently purchasing a dollar of value for $0.50.

4. Acquisition Target.

Lipman is in acquisition mode (recent purchase of Dione in the UK) and HYC would be a great one for them. There are incredible synergies to be had in this type of business. I know that Lipman and Hypercom have discussed merging in the past - to the point of detailing cost savings - but nothing came of it. Given the current valuation of HYC, Lipman will likely have a renewed interest because buying HYC would advance their business far more than Dione has and could provide massive accretion through synergies (not to mention that HYC trades at only a touch over book value).

It is also very possible that a private equity buyer could emerge. The multiples are low enough and GTCR has had great success with Verifone. We have spoken to several private equity firms that are extremely interested in an HYC deal. Given the current position of the company (without senior management), we believe it is an opportune time for the board to explore this option. And I can assure you that many of the large shareholders have made this painfully clear to the board.

Catalyst

1. Imminent Restructuring
2. New Management
3. Share Repurchases
4. Acquisition target