Description

Investment Thesis (Summary):
An investment in IFOX at the current price provides an excellent risk/reward opportunity based on the free cash flow generating ability of the business, with upside over the next 6-18 months in excess of 70%, with downside at less than 5%. As discussed in more detail below, this thesis is based on 1) the strong free cash flow generating ability of the business, coupled with a current trading multiple that is significantly below the growth rate of this free cash flow; 2) the visibility of this free cash flow, given the successful integration and locked in cost savings of a recent transformational acquisition, and the recurring, long-term nature of the company’s contracts; 3) an attractive private market valuation and unique competitive positioning that make an acquisition likely; and 4) strong management incentives to pursue value enhancing activities such as a sale.

Company Description:

Infocrossing (IFOX) provides selective information technology and business process outsourcing services to medium and large enterprises. Operating primarily through a data center model, IFOX manages infrastructure services across a variety of platforms, and operates in a niche in between mom-and-pop providers and larger full-service IT outsourcing companies. Last fall, IFOX completed the acquisition of (i)Structure, effectively its largest competitor (revenue will go from ~$145MM in ’05 to ~$240MM in ’06, with ~75% of that growth coming from the deal).

Summary Statistics
$ Millions, except per share figures
Date: June 26, 2006
Shares Outst. (MM): 22.2
Shares Outst. (MM): 27.9 As converted
Current Stock Price: $10.91
52-Week Low: $6.35
52-Week High: $20.15
Market Capitalization (MM): $242.2
Annual Dividend: $0.00
Dividend Yield: 0.00%
Cash: $11.7 $0.53/sh. (1)
Debt: $139.5 $6.28/sh. (1)
Equity: $110.4 $4.97/sh. (1)
Enterprise Value: $370.0
(1): At Q106.

Based on Fully Diluted, ex-Convert
Year: FCF/Sh.: FCF Yield: EBITDA/Sh: Net Debt/EBITDA
2004A $0.23 2.1% $0.98 3.6x
2005A $0.72 6.6% $1.03 5.7x
2006E $1.29 11.9% $2.08 2.4x
2007P $1.89 17.3% $2.87 1.2x
2008P $2.68 24.6% $3.33 0.4x

Based on Fully Diluted, As Converted
Year: FCF/Sh.: FCF Yield: EBITDA/Sh:
2004A $0.18 1.6% $0.78
2005A $0.58 5.3% $0.82
2006E $1.03 9.4% $1.65
2007P $1.51 13.8% $2.29
2008P $2.14 19.6% $2.65

Investment Thesis:

An investment in IFOX at the current price provides an excellent risk/reward opportunity based on the free cash flow generating ability of the business, with upside over the next 6-18 months in excess of 70%, with downside at less than 5%. As discussed in more detail below, this thesis is based on 1) the strong free cash flow generating ability of the business, coupled with a current trading multiple that is significantly below the growth rate of this free cash flow; 2) the visibility of this free cash flow, given the successful integration and locked in cost savings of a recent transformational acquisition; 3) an attractive private market valuation and unique competitive positioning that make an acquisition likely; and 4) strong management incentives to pursue value enhancing activities such as a sale.

• The Current Price Values the Company at a Low Multiple of Free Cash Flow, and You Are Paying Nothing for the Upside
o I project that the company will do $30MM in FCF in 2006, or $1.35/diluted share and $1.07/diluted share assuming conversion of the convertible notes (more on the convert later). Thus, the company is currently trading at 8X current year FCF/share (almost 12% FCF yield), ex-convert, and just under 10X including the convert. This is a fairly inexpensive valuation for a business with 95%+ recurring revenue, good visibility into growth of free cash flow (I project in excess of 25% per year for at least the next three years) and a very scaleable business model with high incremental operating margins.
o Further, based on my projections for 2007, IFOX is trading at less than 6X FCF/share (greater than 17% FCF yield), ex-convert, and less than 7X FCF/share (approximately14% FCF yield) including the convert, which is very attractive given the growth characteristics of the company’s free cash flow going forward.
o There are only modest execution risks to management’s ability to generate the 2006 FCF numbers mentioned above, as approximately 90% of the FCF increase from 2005-2006 is comprised of contracted revenue acquired in the (i)Structure deal and identifiable cost savings related to the deal. Of these cost savings to be achieved in calendar 2006, approximately 75% were already achieved through the first quarter of 2006, and management has subsequently indicated that there could be further upside to the projected savings (perhaps as much as $2MM incrementally).
o While there is logically a greater degree of execution risk regarding achievement of my 2007 free cash flow projections, relative to 2006, the stock appears to be pricing in a particularly drastic downturn (which is unlikely given the recurring nature of the business and the degree of cost savings already achieved). For example, if the company misses my 2007 projections by 30%, and delivers only $1.51 ex-covert and $1.05 including the convert, even using today’s depressed current multiples of approximately 8x and 10x, respectively, would yield prices of approximately $12.00 and $10.50, respectively. This extreme case, with both depressed free cash flow and maintenance of depressed values, provides considerable downside protection for the stock given today’s price of $10.91.
o Even if today’s low multiples (low relative to growth rate) are maintained, the stock would be worth over $15.00 based on 2007 FCF projections (8X $1.89 ex-convert and 10X $1.51 with convert), suggesting almost 40% upside, with extremely limited downside, per the previous bullet point. If the market gives IFOX even half the multiple of its projected growth rate, then using a 12X multiple and the $1.51 FCF projection (assuming full conversion) would yield a price of over $18.00, or more than 65% above today’s price (again, with limited downside risk).
o The (i)Structure transaction was not only transformative from a financial perspective, but also from an operational standpoint. IFOX acquired a company that routinely won business in head-to-head competition with IFOX, and the high performance salesforce that won those deals. Further, (i)Structure developed a very positive relationship with Accenture: (i)Structure (and now IFOX) would provide the facilities for larger Accenture deals, as the latter is not a facilities based operator (unlike IBM or CSC). IFOX is now on a preferred vendor list for Accenture project managers to use when pursuing a larger technological consulting deal that requires the outsourcing of legacy systems, business applications, etc. This channel will continue to grow in importance for IFOX, and IFOX has very little incremental cost associated with growing this channel.
o Further upside may exist from the potential outsourcing of a portion of IFOX’s workforce to India, the closing of one of IFOX’s five data centers (shrinking capacity and increasing incremental margins) and the growth of IFOX’s Medicare Part D processing business.

• Private Market Valuation is Also Very Attractive
o As the following table shows, at a 9.0x multiple (which is quite reasonable given that industry deals are getting done north of 10.0x and, EBITDA should grow at a mid-teens rate over the next few years if management executes its plan), IFOX would be worth over $22.00/share off 2007 numbers, ex-convert, with nearly 30+% growth after that. Including the shares from conversion (and without giving benefit for the nearly $2.0MM in after-tax free cash flow benefit from the interest savings), IFOX would be worth nearly $18.00/share off 2007 numbers. The equity value increases each year both from growth in EBITDA and from deleveraging as a result of the strong free cash flow generation. These values are approximately 100% and 65% above today’s price.

Private Market Value ex-Convert 2006E 2007P 2008P
Multiple of EBITDA 9.0 9.0 9.0
EBITDA $46.1 $63.7 $73.9
Total Segment Valuation $414.7 $573.4 $665.3
Less: Net Debt 108.4 76.9 32.3
Equity Value $306.3 $496.4 $633.0
Shares Outstanding 22.2 22.2 22.2
Equity Value/Share $13.80 $22.36 $28.51

Private Market Value with Conversion 2006E 2007P 2008P
Multiple of EBITDA 9.0 9.0 9.0
EBITDA $46.1 $63.7 $73.9
Total Segment Valuation $414.7 $573.4 $665.3
Less: Net Debt 108.4 76.9 32.3
Equity Value $306.3 $496.4 $633.0
Shares Outstanding 27.9 27.9 27.9
Equity Value/Share $10.99 $17.81 $22.71

o There is very strong downside protection on this basis as well. While there is some execution risk to these numbers, as discussed above, if you assume no EBITDA growth from 2006 to 2007, and use a lower 8.0X multiple, all else equal, you would get values of with $13.15 ex-conversion, about 20% above today’s price, and $10.46 assuming conversion, roughly today’s price. Using the lower sets of numbers, that’s 65% upside versus flat on the downside.
o There are a range of potential acquirers of the business, including larger domestic players, such as IBM, EDS, CSC and Accenture. Internationally, a suitor might be found in the form of a large Indian outsourcing firm looking to establish a US beachhead. Having such a presence would alleviate potential client concern regarding offshoring of sensitive data and business applications.

• Management Has Strong Incentives to Create Value
o CEO Zach Lonstein, who founded the business in 1984, and who reassumed CEO duties after the IT bubble burst in 2001, owns over 12% of the company (and has been buying more since the (i)Structure deal closed). Robert Wallach, the Vice Chairman owns 3.5%, and Jack Silver, a “friend of the firm” owns over 10%.
o Lonstein has a significant portion of his net wealth tied up in the business, and at 62, with retirement an attractive option in the next few years, would consider a going private transaction or a sale of the business as viable exit/diversification strategies.

 Management, notably Lonstein, has a history of poorly communicating with Wall Street, both in terms of poorly explaining a quarterly earnings miss, not having a conference call when the (i)Structure was announced, etc. While this has provided the opportunity to enter at this price, it has infuriated existing shareholders.
 There is both an opportunity and a reasonably high likelihood that at least one, if not two or three, of the top shareholders could get active should management stumble (as of this memo’s date, there are six institutional holders with greater than 5% positions each). Most have a basis in the low-to-mid teens.


• Risks
o There are execution risks, including the continued integration of (i)Structure, rationalizing the data centers (both in terms of moving up from 50% capacity as well as potentially closing one or two centers; the acquisition brought with it two new centers), and continued integration of the Verizon Health acquisition.
o The company has a nearly 80% debt/capitalization ratio, and has a history of doing dilutive financings (which management stresses were both necessary and a thing of the past). The company must generate free cash flow and pay down debt to make IFOX an attractive acquisition or go-private candidate.
o IFOX must demonstrate consistent organic growth, particularly after having acquired the strong (i)Structure salesforce.
o Continued issues regarding Lonstein communicating poorly on earnings calls and in other communications with Wall Street. This has led to considerable volatility in the stock price over the past two years. The downswing since the last earnings call in May was entirely a result of miscommunication (see the transcript for more detail) rather than any fundamental issues with the business.

Catalyst

1) Continued successful integration of (i)Structure, and resultant cost savings and locked in contractual revenue.
2) Potential Indian JV/outsourcing deal that further enhances operating leverage.
3) Sale of the company.