Intertrust INTER
November 17, 2016 - 9:17am EST by
aaron16
2016 2017
Price: 16.20 EPS 1.42 1.55
Shares Out. (in M): 92 P/E 11.4 10.4
Market Cap (in $M): 1,490 P/FCF 11.4 10.4
Net Debt (in $M): 750 EBIT 0 0
TEV ($): 0 TEV/EBIT 0 0

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Description

Intertrust "IT" is the largest provider of corporate, fund, capital market, and trust services.

This is a very good business / industry which I define as the following:

  1. Recurring, subscription-type revenue
  2. Organic unit growth (billable hours)
  3. Fat margins and operating leverage (40+% EBITDA Margins with 60+% incremental margins)  
  4. Minimal capital requirements
  5. Long runway of high-ROIC acquisition opportunities 
  6. Grew through the GFC

Trading at what I believe to be a great price - 

sub 9x 2018 FCF, 11x 2018 EV/NOPAT assuming no incremental acquisitions

At a very conservative 15.5x forward FCF, which would give an owner an approximately 15% forward free cash flow yield (6+% yield, organically growing 8-10%), the investment would generate a 70+% IRR and 1.8x MOIC to YE2017. Discounting back at 10% gets to fair value of $25.6 or 65% higher today.

Trading in-line with the market at 18x FCF, and significantly below essential service competitors, would drive a near-term return of over 2x MOIC.

 

Furthermore, due to the extremely long run-way and consistency of acquisitions (1 completed every year for the last 6) if they are able to tuck-in another company or two over the next 18 months, it is easy for them to push over $2.5 FCF per share by 2019. 

What they do

For corporations (65% S&P Global 500), funds, capital market entities, and private clients the company provides a range of essential and primarily recurring services across 5 geographic segments: the Netherlands, Luxembourg, Jersey, Cayman, Guernsey, and the Rest of the World.

The mix of business is approximately 45% corporation, 38% Fund / Capital Markets, 17% Private client

For corporations, this includes formation, implementation, domiciliation, legal administration, reporting, and compliance.

A US corporation will set-up a Luxembourg holding company for their European operations due to the numerous tax treaties between Luxembourg and other foreign jurisdictions where the company may have subsidiaries. At implementation there are a bunch of one-time costs around getting the entity set-up, formation documents. The on-going management of the entity will create subscription type revenue, where every year it will require to have directors, board minutes, treasury and other services. At its dissolution there will be another bunch of one-time costs.

For funds, this includes fund launch services, administration, accounting and reporting, transaction, and fiduciary services.

They will advise and assist where to domicile fund, open all relevant accounts, and on-board investors. On-going subscription type revenues include administration services, investor services which processes capital calls, on-going investor monitoring, as well as fiduciary services such as fund directorships, and Authorized Representatives. Additionally, a host of new regulatory services, such as AIFMD, and FATCA provide funds with additional reporting requirements. It is important to note, all these services are not priced as a function of AUM.

For Capital Market clients, they will set up SPVs. The on-going revenues will include portfolio administration, preparation and monitoring of cash flows, monitoring trigger events, investor reporting, and Agent and Bondholder Representative Services.

 

For private clients, they provide structuring and administration to private and corporate trusts, foundations, charitable trusts, pensions and others.

What they don't do

 

IT does not provide tax or legal services.

Drives of Business / Industry

The primary drivers of this business are REGULATION and foreign direct investment. And the underpinning of the industry are bilateral tax treaties, local corporate frameworks and legal protections.

Regulation drives additional substance and reporting requirements as well as introduces additional complexity all which drive billable hours. Furthermore, greater complexity, and sensitivity drives customers to reputable service providers, which drives pricing power.

The demand for entities is driven by capital flows. Corporations investing in new countries, fund launches, capital raises all require corporate entities for proper legal and tax protections. An entity usually lasts 7-10 years and is this wound down with additional one-time revenues around termination.

There is the entity and the number of hours that go into providing all the services for the entity. These services are billed per hour or for a flat fee. Management believes that there will be flat to slightly down entities but due to increasing substance requirements and additional regulatory services that entity complexity and associated billable hours per entity will continue to increase.

 

Furthermore, unlike many consulting / law-firm / advisory companies – IT has much stronger business because it is pre-dominantly not associated with key individuals with large books of business to whom most of the firm’s economics accrue (small exception is Registered Office / Fund Directorship’s in Cayman discussed more below).  IT is a partner to these companies and as best practices separate the tax / financial advice from the management of the structures. Their ability to serve clients across multiple jurisdictions makes them particularly valuable. 

Why does this opportunity exist

While the business has not been expensive since going public in October 2015, after Q3 earnings, two weeks ago, the stock dropped 15%.

The issue has primarily been around their Cayman division. While management, had signaled to the market that there would be on-going issues within Cayman, their lack of precision around the magnitude of the issue, and slightly slower other segment performance in the quarter led them to revise guidance by my estimate approximately 8-10%.

In 2012, IT acquired Walker Management Services. This was a spin-off from Walker's law firm and came with a 4-year no compete. Management was aware that come this year, certain principals of Walker would look to re-take their book of business. This is primarily Registered Office / Fund Directorship business (where there is key-man risk), a handful of people have relationships with large amount of entities - if stay or leave swings numbers. Anticipate to continue in 4Q and then moderate in 2017. 

The rest of business is performing fine – with ex-Cayman growth of slightly over 5% in-line with their medium term guidance. Elian, should be accretive to the growth rate, but from management tone, seems to have also been a little slower in the wake of Brexit. 

Guidance

 

Company had guided to $1.3 of adjusted net income with Elian being 10+% accretive in 2017 and 20% in 2018. With Q3 gave guidance of $1.42 for '16 adjusted for Elian for whole year. I estimate that this is about a 8 cent guidance reduction.

Reinvestment Opportunity 

Corporate and trust services market is fairly fragmented. There are 3 global players, Intertrust, TMF Group (TMF is 1/2 corporate services 1/2 lower margin BPO and has public financials), and Citco. A handful of regional players Corporation Services Corp. in the US, and a handful of more pure-play service providers Sanne PLC (public 20+x FCF). Further, more diversified niche players (all public) include Capita, Walters Klowers (owner of CT Services), and Equiniti. 

IT has completed a reasonable acquisition every year since 2011 with a major acquisition in 2013 (ATC) and Elian which closed in September (adds 33% growth in revenues).

2011: Close Brothers Cayman

2012: Walkers Management Services

2013: ATC

2014: CRS

2015: CorpNordic

2016: Elian

Focus going forward is primarily on Capital Markets and Fund Services or getting a leading position in new geographies (US / Asia).

 

These acquisitions have been extremely synergistic as they have been able to basically cut almost all corporate cost when they are already operating in that geography.

 Company History

IT was spun-out of Fortis, acquired by local Dutch PE firm Waterstone. It was then taken private by BX in 2013. BX levered the business 6.5x. 

 

BX took IT public in October. For such a large company $1.45+ billion there is not a lot of float. BX still owns 33% and management owns another 15%.

Model

So I think this model is fairly conservative - I am giving them 39% EBITA margins in 2018, approximately 500bp below management target of 44%. Even at this significantly reduced level - I get over $1.60 in FCF per share. 

Model is fairly straight-forward. In Netherlands I assume grow at medium term guidance of 5% this is below run-rate, I do same for Luxembourg, which is slightly above run-rate. In Cayman, I assume revenue drops another 16.5% after 18.5% drop in 2016, and that this revenue has 75% incremental margins. I assume it is flat from '17 to '18. In Guernsey I have business growing 10% from '16-'17 which is about in-line with its current constant currency growth, and then 5% in 18. I assume the same for the Rest of the World. For Elian I have the business flat in euro from '16 to '17. Average exchange rate is 1.23 for ‘16 vs run-rate of 1.16 - this offsets 5% growth. I then have them growing 5% from 17 to 18 - this is 400 bps below run-rate growth from prior years. 

I assume they get 11 million of synergies in '17 below anticipated 13 million of synergies. 

In all segments, I assume no operating leverage.

 

To keep this simple, if you think they get to management EBITA margins business would be doing about 1.85 in 2018 FCF. Again, by 2018, they be probably sub 2.5x debt to EBITDA, and at 4x would have capacity of over 400+ million for an acquisition. 

              2014 2015 2016 2017 2018
                       
Total Revenue             394.30 451.91 463.07 474.39 496.11
EBITA             112.80 139.90 177.50 187.74 197.60
                       
Margin             28.61% 30.96% 38.33% 39.57% 39.83%
Revenue YoY growth               14.61% 2.47% 2.45% 4.58%
                       
Interest expense               -19.00 -29.00 -27.00 -25.00
Taxes                 -23.76 -25.72 -27.62
+ non cash interest                 4.00 3.00 2.00
FCF                 128.74 138.02 146.99
                       
Shares outstanding                 92.00 92.00 92.00
                       
FCF per share                 1.40 1.50 1.60
                       
Netherlands                      
Revenue             103.10 112.10 117.93 123.82 130.01
EBITA             65.40 71.80 75.53 79.31 83.27
                       
Margin             0.634336 0.6405 0.6405 0.6405 0.6405
Revenue YoY Growth                 5.20% 5.00% 5.00%
                       
Luxembourg                      
Revenue             65.30 75.30 76.83 80.67 84.70
EBITA             31.00 37.80 38.57 40.49 42.52
                       
Margin             47.47% 50.20% 50.20% 50.20% 50.20%
Revenue YoY Growth                 2.03% 5.00% 5.00%
                       
Cayman Islands                      
Revenue             48.3 58.8 47.9 40 40
EBITA             28.5 35.2 28 21.5 21.5
                       
Margin             0.590062 0.598639 0.542797 0.5 0.5
Revenue YoY Growth                 -18.54% -16.49% 0.00%
                       
Guernsey                      
Revenue             23.80 27.90 27.50 30.25 31.76
EBITA             8.00 10.10 9.96 10.95 11.50
                       
Margin             0.336134 0.362007 0.362007 0.362007 0.362007
Revenue YoY Growth                 -1.43% 10.00% 5.00%
                       
Rest of World                      
Revenue             55.40 70.80 78.53 86.38 90.70
EBITA             16.90 22.00 24.40 26.84 28.18
                       
Margin             30.51% 31.07% 31.07% 31.07% 31.07%
Revenue YoY Growth                 10.92% 10.00% 5.00%
                       
Elian                      
Revenue             98.40 107.01 114.39 113.27 118.94
EBITA             34.44 38.13 43.05 39.65 41.63
                       
Margin             35.00% 35.63% 37.63% 35.00% 35.00%
Revenue YoY Growth                 6.90% -0.98% 5.00%
                       
                       
Revenue             80.00 87.00 93.00 97.65 102.53
EBITA             28.00 31.00 35.00 34.18 35.89
Exchange Rate             1.23 1.23 1.23 1.16 1.16
                       
Margin             35.00% 35.63% 37.63% 35.00% 35.00%
Revenue YoY Growth                 12.90% 5.00% 5.00%
                       
Group HQ + IT             -37 -37 -42 -42 -42
                       
Synergy                   11 11

 

International tax treaties / Corporate taxation / Corporate structuring

At a high level, companies operate foreign entities in order to do business overseas and fund or capital market entities domicile in jurisdictions to get access to desired legal protections.

In order to prevent double taxation, bilateral tax treaties were set-up between countries.

Today there are more than 3,500 treaties between over 90 countries.

Many tax treaties are based on OECD Model Treaty as well as the UN Model, but ultimately these are sovereign documents that are tailored to the desire of each country. Countries compete and one way is through legal and tax policy.

The OECD Model Treaty has 31 articles.

Particularly important is Article 5: Permanent Establishment, which defines when a business is even operating within a country so that it may be subject to taxes in that country. 

Other important articles define how taxes should apply to dividends, interest, royalties, and capital gains.

As it applies to multi-national corporate clients there is a decision about how to structure their local operations.

As the world has become more service, and IP oriented, there are additional questions around a company’s PE, where a sale takes place, and transfer pricing policies.

These decisions, and the corporate structure implemented that reflect that decision are made by the company and its tax counsel. 

These decisions, at times are challenged by tax authorities. Ultimately, there have been numerous local judicial rulings on corporate structures. This has been a constant through time.

Countries can ultimately renegotiate their treaties, and overtime they are continuously updated to reflect the spirit and substance of each jurisdiction.

The most recent conference by the OECD on Base Erosion and Profit Shifting (BEPs). The outcome of which is 15 Action Items that seek to minimize aggressive tax planning that has arisen from the issues above.

IT has been aware of these Action Items for a long-time (BEPs project was announced in 2014) and believe that the increased regulation will drive more substance requirements, which will continue to drive billable hours.

 

Also, recently the CCCTB (Common Consolidated Corporate Tax Base) was re-introduced (previously introduced 2011). This would actually have a negative effect on their business as it seeks to harmonize all tax rates across European member states, but from conversations, this treaty is already dead just as it was last time. It would require all 27 EU members to ratify it, and numerous members, believe that tax policy is a sovereign matter.

Bear case questions

I have sat in a few lunches with management and other investors and a bunch of the questions that are typically asked are the following:

1.       What is exposure to something like Mossack Fonseca / Panama Papers

a.       IT had no direct connection to MF and had 4 total clients that had a connection to MF. IT does not and never has operated in Panama. Furthermore, things like Panama Papers drive clients to reputable service providers.

2.       Does this business just exist as some sort of tax arbitrage?

a.       Companies set-up entities in foreign jurisdictions for numerous reasons, tax is certainly one of them. I think a fun thing to do is go to EDGAR and pull up a company’s 10-K then go to Exhibit 21 where you can see all the major subsidiaries of public companies – and you will see how to companies structure themselves. As mentioned earlier, there are certain aggressive tax planning strategies – these at times get contested – these situations happen to get a lot of press – but they relatively rare. If a garment company owns and operates a factory in Honduras, there is no question about where they operate however the question of permanent establishment becomes much more subjective when operating in the digital economy.

 

b.      What is the impact of repatriation / lowering of taxes in US – this should really have no effect – whether or not you can do a one-time repatriation of your money certainly has no effect, a global harmonization of tax rates would be a negative albeit unlikely, however one would still conduct business through local entities for variety or reasons, legal frame-works, processing local payroll etc. 

I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise hold a material investment in the issuer's securities.

Catalyst

Stabilization of Cayman

General undervaluation

 

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