Description

I recommend the purchase of MICROS Systems, MCRS.  Due to heightened and somewhat exaggerated concern regarding competitive disruption in one of its segments and the general macroeconomic malaise, particularly inEurope, we have the opportunity to buy a great company at a good price. 

MCRS provides hardware, software, and services to the hotel, restaurant, and retail industries.  Approximate revenue breakdown by vertical is 37% hotel, 37% restaurant, and 26% retail.  Revenue is also broken down by service at 67% of revenue, hardware at 21% and software at 12%.  MCRS generates about 60% of its sales internationally and 40% inNorth America.  The company started in the restaurant space and has entered new areas via acquisition and then growing organically.  MCRS has been investing in software as a service, SaaS for over 5 years and mobile payment processing for 20, so it is increasingly leveraged to these growth avenues and its new SaaS offering, Simphony, is likely to drive an upgrade cycle.

Its hotel segment is its crown jewel and its most complex offering.  It is an enterprise information software based system, called Opera, that performs property management and central reservation services, among other functions.  An important feature of which is its connectivity between the hotel and the global distribution system used by online travel agencies.  It is sold as a license or on a subscription basis.  It has a very broad product offering, so there are opportunities to further penetrate existing accounts.  Approximately, 40-50% of segment revenue is maintenance revenue that carries gross margins of 60-70%, which is also recurring in nature.  The rest of its services revenues are generated by web hosting, installations, interfaces, consulting, e-commerce, web design, etc.  Growth drivers recently have been SaaS, which saves customers money on infrastructure and maintenance costs, while providing expedited and uniform updates, and generally making the system cheaper and easier to manage.  Less than 20% of hotel customers are estimated to be SaaS customers now, but it is expected to grow at 10-20%.  Also, driving more traffic through owned websites is important, which MCRS facilitates, because online travel agencies can take 10-30% of a room’s value as commission.

The hotel industry in general has been in recovery from the Great Recession, with revpar growing 5-8% annually over the past few years, although new unit growth remains anemic.  The market size is difficult to estimate because it is very fragmented.  However, MCRS is the dominant provider in the space with an estimated 25% market share among large chain hotels and resorts (although much smaller among independents).  Interestingly, 25% of the market is estimated to be internally sourced, which creates an opportunity because as these systems age many hotel operators are finding it much more efficient to outsource.  The rest of the market is made up of multiple smaller providers with AGYS, the #2 player at less than 1/3 of MCRS’s revenue.  The lack of scale and breadth of the smaller competitors provides fertile grounds for MCRS to increase its penetration in existing accounts.

The restaurant segment provides hardware and software solutions that can be tailored to fit most environments from low to high end, including stadiums and arenas, but smaller, independent restaurants are not really part of the target market due to cost and complexity of the systems.  It mainly provides point of sale solutions that tie in many other ERP applications specific to the restaurant industry.  Restaurants typically operate on thin margins, so driving revenue and optimizing labor and food costs are important considerations, in addition to the cost of investment in technology.  Services revenue is estimated to be about half of this segment, while hardware is about 35%, and the remainder software.  Hardware revenue is the most susceptible part of the business to competition and has been declining, which has been concerning.  About 2/3 of this segment is inNorth America.  A MCRS POS system can cost between $5,000-30,000, so it is a significant investment for a restaurant operator.  Growth drivers for the segment are the efficiencies and savings it brings to restaurant operators, as well as SaaS.

Over the past two decades spending at restaurants has grown 4-5% normally, while it did fall 50bps in ’09.  According to the National Restaurant Association, there are almost 1 million food service locations in theUS, and management says there are 5 million globally, although only about half have any kind of POS system.  MCRS has an installed base of approximately 350,000 locations with 225,000 inNorth America, giving it roughly 20-25% market share.  NCR’s Radiant division also has similar market share.  Another 20% of the market is on more antiquated equipment and the rest is highly fragmented with no other competitor with over 5% share.  Most POS hardware is open source, which allows competitors to sell hardware without having a strong software offering, which has led to continuous new entrants with newer technologies, but much simpler platforms.

The retail segment provides software and services to companies generally in specialty retail with more than 20 locations.  In the past few years acquisitions have grown the international component of this segment.  MCRS does provide a POS system, but also complex, customizable enterprise software with applications for inventory tracking, loyalty programs, business analytics, order management etc.  Revenue in this segment is driven mostly by services.  It is also not the clear leader in this space. 

Retail ERP is an industry that does well over $10 billion annually and competitors include ORCL, SAP, NCR, JDAS, etc, so it is not dominant in this space, but still has a good position in specialized areas.  It is installed in over 700 companies in over 100,000 sites. The market is growing 7-10% annually.  Growth drivers are predominantly unit growth within existing customers and international expansion. 

What makes MCRS a great business?  Qualitatively, MCRS provides critically important products and services to its customers.  Although the investment in the system can be substantial, it is a small part of the cost for launching a location and its ongoing operation.  It is the type of solution operators do not want to have to think about.  They just want it to be highly reliable and to have 24/7 service and support in the event of a problem.  Said differently, the cost is minor compared to being able to process payments quickly and securely in a busy environment and to create a great customer experience.  MCRS’s customers are sticky, which in turn creates pricing power, because of the high costs to switching.  Many of MCRS’s customers are large chains also, so they need something scalable, and switching large amounts of sites would increase the potential for problems.  Low rates of attrition attest to this.  MCRS’s systems provide good value to customers in that they last for 8-10 years.  MCRS has a large installed base that creates economies of scale that are difficult for smaller competitors and new entrants to replicate, particularly in R&D spend, distribution, and service and support.

Quantitatively, between cloud based solutions and maintenance fees, recurring revenues are 43% of the total now, up about 30% in F2Q13.  Capital requirements are generally 1.5-2.5% of revenues.  Gross margins have consistently been over 50% for most of its operating history.  Return on capital has averaged 14% over the past 10 years and has been very stable.  Further, despite its markets being highly fragmented with the threat of new entrants, market share has remained relatively stable and has slightly improved over time (with the exception recently of restaurant hardware).

What are investors concerned about?  There is an emerging threat of disruption from new low cost mobile POS applications, mainly on tablets.  Although there is no real evidence yet of dislocation among restaurant chains and larger, sophisticated restaurants, there has been at smaller, independent restaurants.  Bears on the stock can point to the deceleration of organic growth from the high single digits to under 2% in F1Q13 as potential impact from share loss as a result of this competition.  These types of restaurants are typically not MCRS customers, but the developments are worth paying attention to as it could eventually lead to loss of market share in the restaurant segment, as well as pricing pressure in restaurant hardware, if the trend grows up market.  Furthermore, the loss of hardware share would also lead to loss of higher margin software and maintenance revenues.  Restaurant hardware is probably at least 2/3 of all hardware revenue and at least half of restaurant hardware is branded, so it carries good gross margins, so a margin headwind here is possible, which if it became a real problem could potentially reduce EPS by 15-30 cents.

This competitive threat does not pose that much of a risk to MCRS though.  To date, most of the adoption of tablet POS devices has been in smaller restaurants that MCRS is not even targeting.  Many of the mobile payment centric POS vendors are small companies that can not compete with MCRS’s $20+ million R&D budget and therefore do not have remotely the level of functionality as MCRS, nor the scale to provide service, support and distribution.  POS is just one component of MCRS’s integrated solution that includes a wide array of ERP applications.  Pricing is also not always the most important issue for restaurateurs when selecting a vendor; they need extremely reliable, easy to use solutions.  Furthermore, the pricing differential is not as compelling for these competitors once necessary, additional software and services are layered into the total cost of ownership, which are needed to make them comparable to MCRS.  MCRS is also launching its own branded tablet on the cloud based Simphony platform.

NCR has also gained some share in restaurants because of its strong reseller network and earlier introduction of cloud based solutions, which is not a positive for MCRS, but is more indicative of jostling among existing competitors, rather than a widespread secular transition.  Some of this market share loss is also because MCRS has a strong position in the industry and is priced at a premium, and its apparent unwillingness to compete on price or lower margins.  

There have been quite a few notable retailers announcing significant mobile POS initiatives, as well.  However, the threat is not that great in this segment because hardware is only single digits as a percent of its revenue mix and it is all third party hardware, so margins are negligible in the first place.  In fact, the mobile transition could be a positive for MCRS since the proliferation of mobile devices means more hardware units need a software license, so it can improve revenue growth and profitably.  For example, Finish Line is an existing customer that plans to roll out 3200 handheld devices to staff.  MCRS is not supplying the hardware, but each device requires a software license, so it is incremental revenue.

The economy is probably more to blame for the sluggish top line growth.  40% of sales are toEuropeand its end markets are very sensitive to consumer cycles.  And despite the economic recovery in theUSnew hotel and restaurant unit growth has been slow.  A weaker economic environment could extend sales cycles, increase attrition, and make it harder to pass through price increases.  It is possible that given the arrival of a new CEO and the continued lackluster recovery that management will guide lower on the upcoming earnings call, which could create an attractive entry point for investors.

Despite the competitive and economic headwinds that MCRS is facing, there are also some positive potential catalysts that are being underappreciated.  New cloud based products (Simphony) coupled with a large installed base that has been putting off upgrades could drive a significant upgrade cycle in the restaurant segment.  The typical refresh cycle for POS systems is 8-10 years.  A lot of restaurants have delayed the purchase of an upgrade due to the recession despite an aging installed base that is approaching the end of its useful life, so there could be some pent up demand for the new platform.

Although the timing is uncertain the hotel segment should also benefit from increased outsourcing.  Multinationals often already use MCRS internationally, but remain on proprietary systems domestically, which are rapidly becoming outdated, many of which are almost 15 years old and it is not as cost effective to build to replace.  Marriott, Starwood, and Hilton all use internally developed systems domestically, but have outsourced internationally.  Marriott in particular has publicly discussed reducing its IT budget, which bodes well for MCRS.  Hyatt and Accor already made the switch in ’08 and ’09.  Two large deals are possible that could generate revenue and EPS of $35-50 million and 20-30 cents over a 3-4 year implementation period, while generating $10 million maintenance revenue annually.

MCRS last quarter finalized CEO succession plans, which had been an open question for a while.  New CEO, Peter Altabef, was formerly CEO of Perot Systems from ’04 until it was sold to DELL, at which point he became head of Dell Services until ‘11, so he brings with him good experience in technology services and looks to focus on innovation at MCRS.  The board of directors also recently approved a new 2 million share buyback program.  Valueact Capital also recently disclosed a 7.5% stake in the company.  The company has been well managed in the past, but their presence should encourage more shareholder friendly capital allocation, and possibly even reduce some operating expenditures.  It is noteworthy that MCRS’s balance sheet is under levered, so there is quite a bit of flexibility with what they can do regarding the return of capital to shareholders.

At $42.57 with 79.3 million shares outstanding (and 6.8 million options striking at $34.22) MCRS’s market cap is $3.4 billion.  It has $632 million of cash, no debt, and $3 million minority interest for an enterprise value of $2.8 billion.  For F13 (June, 2013) MCRS should generate at least $1.3 billion in revenue and $2.40 EPS.  In F14 with organic revenue increasing back towards more normal levels with the addition of some recent wins in the retail segment and some operating leverage MCRS should generate $1.45 billion rev and $2.75, as well as $345 million of EBITDA.  MCRS has historically traded in a range of 7.5-14.x EBITDA with a three year average of 11x, so with reversion to that level once some of the competitive and economic concerns dissipate, as well as the possibility of some upside catalysts, there is conservatively 25% upside in the stock.

In summary, the competitive threat is not as great as the market perceives at the moment because it affects a relatively small part of the business and any impact will be felt several years down the road, not imminently.  Also, the economic issues are cyclical and we are able to buy the stock at a time when the European operations are depressed, so MCRS’s franchise value has not been impaired, growth rates will eventually recover, and the longer term outlook is still positive.  MCRS is well managed, geographically diverse, on the cusp of a product upgrade cycle, has a steady recurring revenue base with strong returns on invested capital and trading below historical valuation levels due to short term concerns.

Catalyst