Description
Hypercom Corporation (HYC), a provider of point-of-sale terminals is currently trading at 4.4x EV / EBITDA. The secular trends for POS terminals are extremely strong and driven by the growth of usage of debit cards, upgrades to IP based terminals, EMV compliance and mandates by several foreign central banks. HYC’s closest competitors are Veriphone (PAY) which is trading at 15x EV / EBITDA and Lipman Engineering (LPMA) which is trading at 10x EV / EBITDA. The positive secular tailwinds are resulting in an industry will experience a mid to high teens growth rate over the next several years. We believe that HYC has the ability to generate a 60 – 100% return over the next 12 months and has less than 10% downside risk. Furthermore, the company has a pristine balance sheet with $91M of cash, a lease portfolio that is in the process of being sold for $21M and real estate worth another $30M, all for a company with a market cap of $331M.
HYC was written up earlier this year by beech625. Beech does an excellent job at giving some of the HYC’s history. While the stock has risen since the write-up, we believe that the stock remains massively undervalued and that many of the key risks that existed earlier this year have been mitigated. Furthermore, several hidden nuggets on the balance sheet provide a potential investor with potential for an outsized return with limited downside risk.
PRODUCTS AND SERVICES
Hypercom’s products are pretty straightforward - the company sells point-of-sale (POS) terminals. These are the terminals that a consumer uses to swipe his or her credit / debit card through when paying for an item or service at a checkout counter. The POS terminal captures payment data and routes it across payment networks to be authorized and processed.
MARKET OPPORTUNITY
The company competes in and industry that is experiencing strong secular tailwinds. The industry is in the midst of its biggest upgrade cycle ever in both the US and Europe. In the US, this cycle is driven by several trends:
• Lower telecommunication costs have driven merchants to replace their dial up terminals with broadband terminals that process transactions up to 8x quicker. These broadband terminals are also more sophisticated and can manage loyalty programs, gift card promotions and capture signatures.
• The increased usage and popularity of debit cards has caused many merchants to replace older POS terminals with newer ones that accept debit payments. Debit based payments have been growing at 20%+ growth rate for the past few years and are expected to do continue to do so over the next several years.
In addition to the trends mentioned above, Europe is in the beginning stages of an upgrade cycle that is also being driven by new Europay, MasterCard and Visa (EMV) requirements. The EMV requirements state that merchants must have terminals that meet certain security and functional standards. If a merchant is not in compliance, they will have to assume fraud liability. For a few European nations, 2005 was the compliance deadline. However, over 80% of terminals have yet to upgraded.
Other regions:
Recently, the Chinese central bank has mandated that local merchants be capable of accepting credit and debit cards in time for the 2008 Beijing Olympics. Currently, only 2% of merchants are capable of doing so. Although the China opportunity yet to materialize, one can be assured that it will be a continued growth driver for the industry over the coming years. Similar mandates are being made by many Latin American and Asian countries (although not specifically tied to the Olympics for obvious reasons).
There are several industry pieces that have been written by outside research firms, all agree that the aforementioned trends will result in an industry that grows its top line by 15 – 18% on an annual basis over the next several years.
COMPETITION:
Hypercom primarily competes with three other public companies: Veriphone (PAY), Lipman Engineering (LPMA) and Ingenico (ING FP). These four companies represent 70% of the market for POS terminals. The industry is a very nice “moat” industry and has extremely strong barriers to entry. The barriers to entry are a result of certification processes that require terminal manufacturers to be certified by credit card issuers, payment processors and banks. New players have to navigate an expensive and time-consuming process before they can begin to sell devices. Merchants are often reluctant to go with a new player regardless of price for fear of non-compliance or certification problems. This is why the top four players are essentially an oligopoly and, as a group, continue to take market share from the 30 odd smaller players in the market.
FINANCIALS
2004 2005 2006
Revenue $255M $265M $315M
Gross Profit $103 $100 $123
Gross Margin % 40% 37.7% 39%
EBITDA $18 $17.5M $45M*
EBITDA Margin % 7.5% 6.6% 14.2%**
*New management has already cut $15M of operating expenses from its 2005 expense base during the second half of 2005. We believe there is another $5M to go. Part of the bear case has been that the company’s headcount has been too bloated, a problem that is being corrected in real time.
** PAY EBITDA margins = 18%, LPMA EBITDA margins = 21%. HYC management has stated that “longer term, there is no reason our margins cannot be in-line with those of our competitors.”
VALUATION
Here is where the story gets very interesting. HYC has a $330M market cap, $91M in cash and $8M in debt. Additionally, the company has several nuggets on its balance sheet that make it even cheaper than it appears at face value.
1) Lease portfolio: The company is in the process of selling its lease portfolio for $21M cash (this number has been confirmed with the company). HYC has already received one bid for the portfolio and, in real time, is receiving a second offer. I anticipate a finalized sale within the next 30 – 60 days.
2) Real Estate: The company owns several pieces of real estate, a 142k square foot office building in Arizona, a 23k square foot office floor in Hong Kong and a 102k square foot building in Brazil. We have used outside real estate experts to quantify the value of these real estate holdings and have come up with a valuation range of $30 - $35M. I use $30M to be conservative.
Current market cap: $330M
Cash: - $91M
Lease portfolio: - $21M
Real Estate: - $30M
Debt: + $8M
Adjusted EV: $197M
2006 EBITDA: $45M
Adjusted EV / EBITDA: 4.4x
We believe that Veriphone is likely overvalued at 15x forward EV / EBITDA and that Lipman is a better proxy at 10x forward EV / EBITDA. To be conservative, I will use multiples that are a 30% and 10% discount to Lipman and a 53% and 40% discount to Veriphone.
Share price at 7x EV / EBITDA (53% discount to PAY and 30% discount to LPMA): $10.14 (60% upside potential)
Share price at 9x EV / EBITDA (40% discount to PAY and 10% discount to LPMA): $13.04 (100% upside potential)
SO WHY IS IT SO CHEAP?
Hypercom has been a very inconsistent performer to say the least. Out of the past seven quarters, five have been disappointments. Without getting into too much history, the prior management team was poor operators and was the result of four of these disappointments, all during 2004. During the second and third quarters new management, including a new CEO (who was a board member) and CFO were hired. More recently, the company missed 2Q consensus on gross margin issues (discussed below) and put up an in-line Q3 (also discussed below) which sent the stock up 10% in one day, only to have it retreat back down to current levels. The 10% jump on an in-line quarter gives an inkling as to how undervalued the stock is. At current levels, the stock has every bit of bad news possible priced in, and then some.
Q2 results: During Q2 the company announced gross margins that fell from roughly 40% to 36.5%. The company blamed the shortfall in gross margins to the fact that it had not yet received certifications on three major products and was forced to sell older products at lower margins to keep their channels open. On the conference call, management did not give details around the timing of certifications but did use a baseball analogy to say that they were at the first pitch of certifying one new product (M2100), the first few innings of another (T2100) and the middle innings of a third (L4100). The street interpreted this as saying the company would not have the certifications ready to start selling these products until AT LEAST mid 2006 and that gross margins would continue to suffer as a result.
Q3 results (second week of November): During Q3, gross margins rebounded to 38.2%, a level that most analysts did not have the company reaching till Q4 next year. Additionally, the company announced during the quarter that it had received worldwide certifications on the product they were supposedly “at the first pitch” on during Q2 and that they were well ahead of street expectations on certification for the other two new products. These products were key to showing growth into next year. Furthermore, the company announced a share buyback that represented 6% of the shares outstanding.
Now….fast forward to November 30th. One sell side analyst happen to lob in a call to management and learn that the Q4 top line was going to be light due to the TIMING of shipments (terminal sales are quite lumpy and at times, difficult to predict). This timing would result in lower Q4 revenues but should be made up in Q1 2006. Management had not given guidance but the street was too high to begin given the fact that last years Q4 had additional revenue that was supposed to be booked in Q3 but got pushed to Q4. The sell side firm spooked the market and the stock came all the way back to the level it is currently trading at.
WHAT WE KNOW TODAY THAT WE DID NOT KNOW 6 MONTHS AGO:
1) Certifications, certifications, certifications. I cannot say this enough times or emphasize its importance enough. It was the single biggest risk that the company faced this year – not having its products ready in time to sell during 2006. On ALL accounts, the company is WELL ahead of street expectations. As a result, we believe that margin assumptions for 2006 are too conservative (and the few analysts that cover the name will agree in offline conversations).
2) Operating margin improvements. This company is one that was way too fat during the first half of this year. Its operating expenses were out of whack with those of its competitors. The new management team has taken a careful look at these expenses and has made $15M of operating cost improvements (mostly headcount reductions as well as some streamlining of manufacturing processes) that we will see the full benefit of during 2006. HYC is continuing to evaluate its expense structure and we believe, is contemplating an additional $5M expense reduction for 2006. This $20M will flow straight through to EBITDA and we believe, our $45M EBITDA assumption for 2006 is a conservative one.
3) Share repurchases: When the company released its Q3 numbers, it also announced a $20M share repurchase program. This represents approximately 6% of the shares outstanding. With $91M in cash and another $21M coming in the door for the sale of the lease portfolio over the next 30 – 60 days, we believe that the company will either announce additional share repurchases and / or pay a special dividend. Street expectations do not incorporate the 6% share repurchase program which could easily grow to 12% or more given the strength of the balance sheet.
WHY THE DOWNSIDE IS SO LIMITED:
We believe that the downside in the stock is 10% at most from these levels for several reasons. The most important reason is private equity interest. I am personally familiar with several top tier private equity firms that are taking a close look at Hypercom. It is the type of situation that private equity players drool over – strong secular tailwinds, an extremely cheap multiple, a management team that is willing to sell, margins that can be improved through restructuring and a very strong balance sheet that can easily be levered (not to mention the potential for sale / leaseback transactions of the real estate holdings). The company will readily admit that there was lots of interest when the stock was at $5, especially since the company has a tangible book value of $4 (in mostly liquid assets). If we assume that a private equity firm will have to pay a minimum 15% premium to get a deal done (I believe the premium would be higher but I’ll use 15% for arguments sake), this puts a floor at $5.75, or 9% below the current price. Furthermore, $5.75 also puts the stocks EV / EBITDA multiple below 4x, a level at which it would hard to argue a company facing such strong demand prospects deserves. Let us not forget that HYC is competing in a growth industry experiencing strong secular tailwinds, not a sleepy industrial or cyclical industry growing at GDP. Finally, we believe that the industry will continue to consolidate in 2006. Hypercom represents a prime acquisition candidate for either Veriphone or Lipman and at current levels, is massively accretive to either company.
RISKS
Certifications take longer than expected
Competition from Veriphone and Lipman
General industry pricing pressures
CATALYSTS
Sale of the lease portfolio
Investor realization of the enormous valuation discrepancy between HYC and its peers
Announced share repurchases = 6% of outstanding shares
Additional share repurchases and / or special dividend
Continued restructuring
Certifications that are ahead of street expectations
Improving gross and operating margins
Potential sale to either private equity or strategic buyer
Catalyst
Sale of the lease portfolio
Investor realization of the enormous valuation discrepancy between HYC and its peers
Announced share repurchases = 6% of outstanding shares
Additional share repurchases and / or special dividend
Continued restructuring
Certifications that are ahead of street expectations
Improving gross and operating margins
Potential sale to either private equity or strategic buyer