Description

HYPERCOM CORPORATION (NYSE:HYC)                               December 29, 2008

 

Ticker: HYC

Price: $0.85

Shares Outstanding: 53.4MM

Mkt. Cap: $45.4MM

Enterprise Value: $60.4MM

Fiscal Year End: December 31

 

Investment Thesis:

An investment in the shares of Hypercom Corporation (HYC) provides an exceptional risk/reward opportunity at current prices.  We believe that HYC is trading well below any reasonable downside case, and that over the next one to two years, under conservative assumptions, that the stock will be worth more than the $6.25 per share offer the company turned down earlier this year.  That is more than a seven-fold increase from today’s prices.  The primary catalysts for unlocking this value will be: 1) continued fundamental improvement for HYC, driven by strong secular growth drivers and improved gross margins resulting from improved products mix and the recent transition to contract manufacturing; 2) continued benefits from the integration of a significant acquisition; and 3) further industry consolidation, in which either HYC will likely be acquired.

 

Company Description:

HYC is the world’s third largest manufacturer of electronic payment terminals.  The company designs, manufactures and markets electronic payment products and solutions, including point-of-sale (POS) terminals, related peripheral devices, networking equipment and software.  The company also services such equipment in some countries.  HYC’s customers include financial institutions, independent sales organizations (ISOs), large retailers and distributors.  The product suite primarily addresses end markets in banking, retail and quick service restaurants, with additional applications in healthcare, transportation and various unattended and prepaid formats.  The company is based in Scottsdale, Arizona, and has a global footprint with particular emphasis in Latin America and Asia-Pacific; in terms of market share, HYC is the #3 player behind France-based Ingenico and US-based VeriFone Holdings.  These three players have approximately 2/3 of the market, with the remainder being fragmented.

 

Significant Events:

Just over a year ago, HYC announced that it had entered into exclusive negotiations with Thales SA to acquire its e-Transactions business line, a leading provider of secure card payment solutions in France, Germany, the United Kingdom, Spain, Belgium and Sweden.  In February 2008, just as HYC was about to sign the formal agreements for the Thales transaction, Ingenico made an unsolicited $6.25 per share offer for HYC (HYC was trading just below $4.00 per share at the time).  HYC ultimately turned down the offer so that it could complete the Thales transaction, believing that it could create a more valuable one to two years out by doing so.  The deal closed on April 1 of this year, and will add approximately $125MM of revenue for nine months in 2008.

 

HYC financed the transaction with $60 million of existing cash on hand, combined with a $60 million investment from private equity firm Francisco Partners (a four year loan, with a 10% interest rate and warrants for 10 million shares, with a $5.00 exercise price; with interest that may be capitalized and added to principal).  The combination of the two businesses has considerably strengthened HYC’s footprint in Western Europe, provided additional talented people to HYC’s global team (both in management and on the board, through the Francisco relationship), increased economies of scale, and deepened and diversified HYC’s R&D efforts, all of which will allow HYC to more quickly build market share while driving significant operating margin improvement.

 

Since the deal closed, there has been considerable insider buying, particularly by members of the Board of Directors.  These purchases have ranged from current prices on recent purchases to prices in the $4.00 range earlier this year.  We believe that these purchases were done to signal confidence in the combined business and also to suggest that recent guidance misses by competitor VeriFone and recent forced sales of HYC stock resulting from hedge fund liquidations do not reflect the current state of business for HYC.    

 

Summary Financials:

 

	FY2007A	FY2008E	FY2009E	FY2010E
Revenue	$293.8	$442.7	$506.0	$541.4
EBITDA	($2.6)	$24.2	$43.5	$62.1
EPS	-$0.14	$0.01	$0.21	$0.44
FCF/Share	$0.12	$0.17	$0.43	$0.66
Net Debt	($124.1)	$18.7	($2.6)	($38.2)

Note: EPS and FCF/Share calculations include the additional 10MM shares from the Francisco warrants, even though these are well out of the money today.  Exclusive of these additional shares, the EPS and FCF/Share numbers would be 19% higher for 2009 and 2010.

 

Valuation:

 

1)      EV/EBITDA: At current enterprise value, HYC is trading at 1.4x FY09 EBITDA and less than 1.0x FY10 EBITDA.  At just 5x FY10 EBITDA, a significant discount to both its growth rate and to the 12x FY10 standalone EBITDA multiple implied by the Ingenico offer, HYC shares would be worth $4.65 per share inclusive of the additional shares from the warrants, more than five times today’s price.  Add in the additional $1.00 plus they’ll generate in cash between now and then and you’re at over $5.70 per share, more than six times today’s price.  Each additional turn of EBITDA above that is approximately another $1.00 per share of value; so half the Ingenico offer multiple plus cash gets you over $6.70, more than the original Ingenico offer price.  As for the comps, VeriFone, even after its stock has been battered by numerous accounting problems and guidance misses, still trades at 6x FY10 EBITDA.  Industry leader Ingenico has seen its stock drop by over 50% in the past two months despite strong fundamental performance, and is trading at just over 3x FY10 EBITDA.  Even at 3x FY10, HYC would be worth $2.70 per share before the $1.00 plus of cash build, more than triple the current price.

2)       EV/Revenue: At current enterprise value, HYC is trading at 0.12x FY09 Revenue (not too different for FY08 and FY10), a full turn below the forward EV/Revenue valuation implied by the Ingenico offer.  At just 0.5x FY09 EBITDA, HYC shares would be worth $4.00 per share inclusive of the additional shares from the warrants, more than four times today’s price.  Add in the additional $1.00 plus they’ll generate in cash between now and then and you’re at over $5.00 per share, nearly six times today’s price.  Ingenico currently trades at 0.5x FY09 Revenue and VeriFone at 0.9x FY09 Revenue.  Because HYC is in the early stages of improving its margins via contract manufacturing (not to mention gaining SG&A and R&D efficiencies from the e-Transactions acquisition), while Ingenico has already seen the gross margin benefits from an earlier transition to contract manufacturing, an EV/Revenue valuation is an instructive tool for capturing relative valuation across companies in the same business with different cost structures.

3)      Synergies: HYC has approximately $90 million in SG&A expenses.  Based on our conversations with industry participants, we believe that at least $30 million in synergies can be achieved through cost cuts following an acquisition of HYC.  Therefore, at today’s valuation, you are paying two times those synergies and getting a profitable, cash generating business with increasing margins, improving cash flow and a strong balance sheet (will be net debt free by year end 2009 and there are no meaningful covenants on the Francisco debt) for free.  At just five times the synergy estimate, using the fully diluted share count, and giving no value to the nearly $0.5 billion profitable business, you’d have a value of $2.15 per share, two and a half times today’s price.

4)      Downside: We have been reasonably conservative in our estimates.  For instance, we are assuming no growth in the acquired business in FY09, despite the ability to sell its products through a broader distribution channel or the ability to sell legacy HYC products into the Thales channel.  Similarly, we have the combined business with FY10 EBITDA margins that are still 700 basis points behind trailing Ingenico margins and gross margins that are several hundred basis points lower than Ingenico, despite the identifiable savings that HYC will gain from contract manufacturing over the next 8-12 quarters.  Nonetheless, we constructed a downside scenario in which the following occur: a) half of the acquired business disappears; b) there is no growth in the existing business; and, c) they achieve no incremental margin benefits (despite the transition to contract manufacturing, the identifiable synergies from the Thales deal, etc.).   In such a scenario, HYC would generate $26 million in EBITDA and $0.25 in free cash flow.  At today’s valuation, HYC is trading at 2.3x this unrealistic case’s EBITDA; with the cash generation they’d be a half turn below that.  Given the unrealistic nature of these bearish assumptions individually, let alone collectively, it appears that today’s valuation has more than priced in any reasonable downside scenario. 

 

Business Opportunity:

After several years of uncompetitive products and management missteps, new management has the company on track for success on several fronts.  New CEO Philippe Tartavull, who took office just over a year ago (he had been a board member) has taken several key steps.  He reorganized the sales force to more efficiently sell products directly in markets in which the company has sufficient presence, and through distributors in markets in which the company does not.  He completed the company’s shift to contract manufacturing, exited certain low or negative margin service contracts, and held the line on product pricing, the combined impact of which will yield over seven hundred points of gross margin improvement over the next few years.  Lastly, he used the strength of the company’s new product line to lead a recapturing of market share in North America.

 

One particular area of growth for HYC is in the multilane channel, involving sales of multiple terminals to a large retailer with many checkout lanes.  If you’ve bought something at a Best Buy recently, you might have noticed the new payment terminals that you swiped your credit card through.  These Symbol-branded terminals, integrated with the checkout scanner, are the first major win for the combined Hypercom-Symbol (part of Motorola) partnership.  HYC manufactures these multilane devices, and in general, Symbol’s salesforce sells them.  HYC still has some house accounts, such as Target, with which it maintains the sales relationship.  Multilane sales represented 20% of HYC’s business just over two years ago, before the company transitioned to the Symbol salesforce, and we believe that the market has forgotten about this business because there has been nothing to show from the Symbol relationship until now (major retailers like Best Buy were waiting for terminals that were equipped with the latest security and compliance standards, which became available late in the fourth quarter of 2007).  Since the Best Buy deal, the company has won several other big national multilane deals, including Target and CVS.  Thales’ Western European customers present a large potential base of additional customers for this product.  Further, HYC recently announced a big contract win for Germany’s new healthcare card system.  This opportunity alone could produce several years of $30MM in revenue with 40% gross margins.  Similar opportunities involving unattended terminals are also in the pipeline.

 

Further, security concerns have prompted numerous Payment Card Industry (PCI) initiatives and standards for the retail industry, the benefits of which HYC is well positioned to capture.  First, the growth in debit card use has led to the establishment of the PCI-PED (PIN Entry Device) standard, which relates to the physical security of a terminal that accepts PIN entry for debit transaction.  All new terminals purchased for use in PIN debit acceptance must be PCI-PED approved, and HYC has more PCI-PED approved devices than any other vendor.  Second, PCI-DSS (Data Security Standard) relates to the customer’s complete network (not just the terminal) and an audit process governs the compliance with this standard, which measures whether retailers’ data is susceptible to breach.  To address this standard, HYC launched Hypersafe Secure, an end-to-end encryption scheme that keeps cardholder data secure from point-of-sale to the processor.  Visa, for example, has mandated various levels of compliance that all of its accepting merchants and service providers must adhere by either September 2009 or 2010, depending upon merchant or provider size.  This will lead to incremental product purchases, particularly among multilane customers (given how much data they capture).  Last, a new set of initiatives surrounding Payment Applications (PA-DSS) will prompt a new push for compliance in payment terminal applications.  HYC is developing applications around both integrated and standalone terminals.   

 

With all of the doom and gloom in the retail space related to growth prospects, possible retail bankruptcies, etc., we think that the market is ignoring the probable contributions from multilane, healthcare, unattended and security-based secular growth.  These contributions should at least offset any weakness in the retail or financial services areas.

 

Conclusion

We believe HYC is well positioned to grow its top-line because of its well received new product family, the cross-selling opportunities provided by the e-Transactions acquisition and the secular security-based growth initiatives.  Further we believe that HYC will see meaningful margin expansion from its contract manufacturing shift, new product sales and improving mix, and SG&A and R&D synergies from the acquisition.  We are encouraged by continued insider purchases since the Spring close of the Thales deal and the negative VeriFone announcements.  Further, industrial logic points to Ingenico coming back to buy the now bigger HYC to strengthen its North American presence, and to take advantage of HYC’s strong new product line and synergy opportunities.  At current prices, shares of HYC do not reflect any of the revenue, margin or free cash flow opportunities, let alone the possibility of another bid from Ingenico.  With reasonable downside well north of current prices, we find an investment in HYC at current prices to be extremely attractive.

Catalyst

The primary catalysts for unlocking this value will be: 1) continued fundamental improvement for HYC, driven by strong secular growth drivers and improved gross margins resulting from improved products mix and the recent transition to contract manufacturing; 2) continued benefits from the integration of a significant acquisition; and 3) further industry consolidation, in which either HYC will likely be acquired.